For businesses small and large, cash flow is a key indicator of a company’s financial health.
There are a number of ways to measure cash flow. The simplest is comparing bank statement balances from one month to the next. The difference will indicate cash flow vs free cash flow.
But financial professionals generally use more sophisticated means to measure cash flow, namely free cash flow and operating cash flow. What are the differences? Let’s find out.
Free cash flow is a common tool to analyze a business’s health. Operating cash flow, on the other hand, is primarily used to measure a business’ value.
Often referred to as FCF, free cash flow is the cash that a business generates during its normal operations minus money spent on capital expenditures like property or equipment. Essentially, FCF is the “free,” remaining cash left to the company after it pays its expenses.
For that reason, investors use this metric to evaluate the financial stability of a business and how effectively it manages its capital to generate a profit. Likewise, financial industry professionals will look at FCF to ensure that a company is wisely using its resources.
An excess of free cash flow vs net cash flow is a good indicator that a business is financially stable. Free cash flow is a common measure of financial performance, similar to earnings.
The amount of cash available is used in a number of ways to evaluate a company’s position.
One primary way is to determine the amount of dividends a company can pay its investors. If a company still has free cash available after paying out its dividends, that is one metric indicating the health of a company. In fact, if free cash exceeds the dividend payments, it likely means that the business can increase its dividends in the future.
The free cash flow number is also used to judge how much money a company possesses to pay creditors. This is a useful number for a bank to know, since it indicates if the company can repay a loan. It also is a good sign that the business can finance further loans.
Operating cash flow is calculated by taking total revenue and then subtracting operating expenses. Recorded on a company’s cash flow statement, operating cash flow is reported quarterly and annually. Operating cash flow is a good measure of whether a company has enough cash to maintain, and even expand, operations. It can also be used to determine if a business would benefit from external financing.
Financial analysts sometimes favor the operating cash flow vs free cash flow number because it provides a clearer picture of the current reality of the business operations.
For example, let’s say a company makes a big sale that is a boost to quarterly revenue. That’s good news, right? It is, but what if the same company is having difficulty collecting payments? In that case, the big sale is a nice number on a spreadsheet but doesn’t really help a company’s bottom line.
An operating cash flow number can also be deceptive as it relates to fixed assets. Let’s say a business has a good amount of operating cash flow but reports low net income because it holds a lot of property or other fixed assets. In that case, the operating cash flow number tells us less than it appears.
We’ve already seen that free cash flow vs operating cash flow is often a question of who is using the numbers and for what purpose.
For example, a company executive may want to use operating cash flow to analyze trends in spending and overhead costs. By improving the way a business procures products or pays operators, it can be more profitable. At the same time, an investor might want to know about free cash flow to determine if a company is worthy of further interest.
These two financial measurements also differ in their scope: free cash flow includes capital expenditures and debt while operating cash flow includes only the profits generated by a company’s operations.
Knowing the difference between the two cash flow measurements are a key to business success.