Are you familiar with the terms “cash flow” and “free cash flow”? While they might sound similar, understanding the difference between them is crucial for any business owner or investor.
Cash Flow refers to the movement of money into and out of a company, while Free Cash Flow represents the cash generated by a company after deducting capital expenditures necessary for maintaining and expanding its operations.
Cash vs. Free Cash Flow
|Cash Flow||Free Cash Flow|
|Cash Flow represents the movement of money into and out of a company, measuring its liquidity and operating activities.||Free Cash Flow is the cash generated by a company after deducting capital expenditures required for maintaining and expanding operations.|
|It is calculated by summing cash inflows and outflows from operating, investing, and financing activities.||It is calculated by subtracting capital expenditures from operating cash flow.|
|Cash Flow assesses a company’s ability to meet its short-term obligations, manage day-to-day operations, and generate profits.||Free Cash Flow measures the cash available for discretionary spending, debt repayment, investments, and shareholder distributions.|
|It focuses on the overall liquidity and financial health of a company.||It specifically focuses on the cash available for strategic decision-making and value creation.|
|Cash Flow represents cash transactions during a specific period (e.g., monthly, quarterly, annually).||Free Cash Flow represents the cash generated over a specific period after considering capital expenditure needs.|
|It does not account for the timing and amount of capital expenditures required for maintaining and expanding operations.||It accounts for capital expenditures, providing a more accurate measure of the cash available for investments and future growth.|
What are Cash and Free Cash Flow?
Cash flow is the money that comes in and goes out of a company. It’s important to understand cash flow because it can be used to measure a company’s financial health.
Free cash flow is important because it shows how much money a company has available to pay its shareholders, creditors, and employees.
A company with strong free cash flow can weather economic downturns and continue to grow, while a company with weak free cash flow may have to cut back on its operations or even declare bankruptcy.
For most companies, free cash flow is calculated as operating cash flow minus capital expenditures. Capital expenditures are the funds used to purchase or upgrade equipment, property, or other long-term assets.
Free cash flow can also be calculated as net income plus non-cash charges such as depreciation and amortization, minus dividends paid out to shareholders.
Pros & cons of each
- Gives a clear picture of all the money coming in and out of a company.
- Can help identify trends over time.
- Helps assess a company’s overall financial health.
- Does not take into account operating expenses, so it may not give an accurate picture of how much cash a company actually has on hand.
Free Cash Flow:
- Provides a more accurate picture of how much money a company has available to pay its bills, invest in new projects, or return to shareholders.
- Can be used to assess whether a company is generating enough cash to cover its costs.
- Limited reinvestment options.
- Potential for cash drain.
- Vulnerable to economic downturns.
How to calculate Cash and Free Cash Flow
- The formula for calculating Cash Flow is as follows:
Cash Flow = Net Income + Non-cash Expenses + Changes in Working Capital
- Net Income: This can be found in the company’s income statement.
- Non-cash Expenses: These are expenses that do not involve an actual outflow of cash, such as depreciation and amortization. You can find this information in the company’s income statement or cash flow statement.
- Changes in Working Capital: Working capital is the difference between current assets and current liabilities. Changes in working capital involve changes in the company’s short-term assets (e.g., accounts receivable, inventory) and liabilities (e.g., accounts payable, accrued expenses) over a period. This information is available on the company’s balance sheet.
- Free Cash Flow is calculated using the following formula:
Free Cash Flow = Cash Flow from Operations – Capital Expenditures
- Cash Flow from Operations: This value can be obtained from the cash flow statement, specifically the operating activities section.
- Capital Expenditures: These are the expenses incurred for acquiring or upgrading physical assets like property, plant, and equipment (PP&E). You can find this information in the company’s cash flow statement or in the notes to the financial statements.
By subtracting capital expenditures from the cash flow from operations, you determine the amount of cash available for other purposes such as debt repayment, dividend payments, or investments.
Key differences between Cash and Free Cash Flow
- Inclusion of Capital Expenditures: Cash Flow includes all cash inflows and outflows from a company’s operations, investing activities, and financing activities. It provides a broader view of the company’s overall cash movements. Free Cash Flow specifically focuses on the cash generated or available for discretionary purposes after accounting for capital expenditures. Free Cash Flow subtracts capital expenditures from the Cash Flow to determine the cash available for other uses like debt repayment, dividends, or investments.
- Focus on Cash Available for Discretionary Use: Cash Flow measures the overall cash generated by a company, including cash used for day-to-day operations and cash invested in long-term assets or borrowed for financing activities. It provides an indication of the company’s ability to generate cash from its core operations and overall cash management. In contrast, Free Cash Flow is more focused on the cash available for discretionary use, as it deducts capital expenditures from the Cash Flow. Free Cash Flow highlights the cash that a company can allocate to investments, debt reduction, shareholder distributions, or other strategic purposes.
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Knowing how to read and interpret a company’s cash flow statement can give you valuable insight into its financial health. With this information in hand, investors can make informed decisions when it comes to investing in companies and assessing their risk levels.