Understanding the intricacies of a company’s cash flow is crucial for making informed investment decisions. As an investor, you need to look beyond profits and evaluate the company’s ability to generate cash. But with terms like “cash flow”, “free cash flow”, “operating cash flow” and more being thrown around, it can get confusing to distinguish between them.
In this comprehensive guide, I will explain the key differences between free cash flow and cash flow and why it matters for investors.
What is Cash Flow?
Cash flow refers to the net amount of cash and cash equivalents entering and leaving a company It represents the money that comes in and goes out of a business during a defined period, usually a quarter or a year
Positive cash flow indicates a company’s liquid assets are increasing, allowing it to settle debts, reinvest in the business, pay dividends, and cover operating expenses. Negative cash flow means more money is flowing out than coming in.
On the financial statements, cash flow is reported on the cash flow statement. This statement has three key sections – operating, investing, and financing activities.
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Operating activities include cash generated from day-to-day business operations and account for factors like changes in inventory, receivables, and payables.
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Investing activities include cash used for investments like purchasing fixed assets, acquiring a business, or buying and selling securities.
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Financing activities involve cash from financing the business – including borrowing and repaying debt, issuing and redeeming equity shares, and paying dividends.
Adding up the net cash from all three activities gives the total cash flow for that period.
What is Free Cash Flow?
Free cash flow (FCF) refers to the cash remaining after a company has paid for its operating expenses and capital expenditures. It represents the cash freely available for management to distribute to shareholders via dividends/buybacks or deploy into new investments.
To calculate free cash flow:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
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Operating cash flow is the cash generated from regular business operations, as reported on the cash flow statement.
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Capital expenditures (CapEx) is the money spent to acquire, upgrade, and maintain physical assets like property and equipment. This expenditure is essential for the company to operate and grow.
Subtracting CapEx from operating cash flow leaves you with the “free” cash that’s up for grabs.
Positive and growing free cash flow indicates the company is generating enough cash to sustain and expand operations while also having surplus to return to shareholders. Declining free cash flow may mean the company is over-investing in unproductive assets.
Key Differences Between Free Cash Flow and Cash Flow
While related, free cash flow and cash flow are distinctly different metrics that serve different purposes for analysis. Here are some key points of difference:
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Cash flow represents the actual total movement of cash into and out of the company. Free cash flow strips out essential capital spending to show how much discretionary cash is left over.
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Cash flow provides insight into all three major activities – operating, investing, and financing. Free cash flow focuses only on cash from operations minus capital investments.
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Cash flow is reported directly on the financial statements. Free cash flow requires additional calculation using numbers from the statements.
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Cash flow includes changes in balance sheet accounts like inventory and payables. These non-cash items are excluded from free cash flow.
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Positive cash flow indicates adequate liquidity to run the business. Positive free cash flow specifically shows the company’s financial flexibility for dividends, buybacks, acquisitions, debt paydowns, etc.
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Cash flow gives a snapshot of the company’s current cash position. Free cash flow helps estimate future cash available for distribution.
Why Compare Free Cash Flow and Cash Flow?
By comparing free cash flow and overall cash flow, investors can better understand:
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Financial flexibility – A company may have positive cash flow, but negative free cash flow due to heavy capital spending. This limits its flexibility to reward shareholders.
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Quality of earnings – Positive free cash flow helps validate profits reported on the income statement. Non-cash expenses like depreciation lower profits but not cash flow.
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Reinvestment needs – Consistently negative free cash flow may signal issues with the business model requiring more cash investment.
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Sustainability of dividends – Management can fund dividends from cash reserves for some time despite weak free cash flow. But this is not sustainable forever.
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Acquisition risks – Overpaying for acquisitions can destroy long-term shareholder value. Evaluating free cash flow helps assess if the company can afford it.
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Financial health – Declining free cash flow year-over-year may indicate future liquidity issues as operating cash gets consumed by excessive spending.
In essence, comparing free cash flow with overall cash flow provides a more complete picture of how efficiently the company is generating cash and utilizing it to create shareholder value.
Real Company Example: Exxon Mobil Q1 2018 Cash Flows
Let’s look at a real example using Exxon Mobil’s cash flow statement for Q1 2018:
Cash Flow
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Exxon reported total cash flow of $4.125 billion for the quarter.
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This factors in cash from operating ($8.519 billion), investing (-$3.349 billion capital spending) and financing activities (-$1.045 billion)
Free Cash Flow
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Starting with operating cash flow of $8.519 billion
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Deducting capital expenditures of $3.349 billion
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Leaves free cash flow of $5.17 billion
Comparing the two shows that although Exxon had positive overall cash flow, significant portions were eaten up by capital investment and changes in financing like repaying debt. But free cash flow remained solid at $5.17 billion for discretionary uses.
Key Takeaways:
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Cash flow refers to total net cash generated from business activities during a period. Free cash flow specifically represents cash available after operational and capital spending needs are met.
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Cash flow provides a snapshot of the company’s liquidity and ability to fund day-to-day operations. Free cash flow shows broader financial flexibility.
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Investors should compare cash flow and free cash flow to better evaluate earnings quality, reinvestment needs, acquisition risks, dividend coverage and the company’s overall financial health.
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Positive free cash flow demonstrates the company’s ability to produce discretionary cash from operations for distribution to shareholders. But declining free cash flow may signal future liquidity issues.
So next time you come across “cash flow” or “free cash flow”, remember – they are closely connected, but distinct metrics that together reveal a lot about a company’s financial strength, cash generation ability and shareholder value creation. Analyzing both provides powerful insights for making informed investment decisions.
Operating Cash Flow
Operating cash flow is an important metric because it shows investors whether or not a company has enough funds coming in to pay its bills, taxes, or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long term.
Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a companys cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.
Free Cash Flow and Dividends
The amount of cash flow available is usually used to calculate how likely a company can make its dividend payments. Dividends are cash payments to investors as a reward for owning the stock. If a company is generating free cash flow that exceeds dividend payments, its likely to be seen as favorable to investors, and it could mean that the company has enough cash to increase the dividend in the future.
Investors use a companys free cash flow to equity figure to determine how much cash is remaining to pay for dividends. Free cash flow to equity is a specific free cash flow measure that calculates the cash available to only equity investors. It is the cash available after the debt holders have been paid and after debt issues and repayments have been accounted for.
Many analysts feel dividend outlays are just as important an expense as capital expenditures. The board of directors of a company may elect to reduce a dividend payment. However, this usually has a negative effect on the stock price, as investors tend to sell holdings in companies that reduce dividends.
What Is Free Cash Flow? FCF Explained
Is free cash flow the same as profit?
Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet .
Can a company have negative free cash flow?
When the reported operating cash flow is negative to begin with as a result of negative earnings. If a company generates negative profits that also don’t result in a positive operating cash flow after adjusting for non-cash expenses, the business will report negative free cash flow.
What does free cash flow mean?
Free cash flow (FCF) is the cash flow available for the company to repay creditors or pay dividends and interest to investors. Some investors prefer to use FCF or FCF per share over earnings or
