Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
  1. Cash Flow Indicator Ratios: Introduction
  2. Cash Flow Indicator Ratios: Operating Cash Flow/Sales Ratio
  3. Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
  4. Cash Flow Indicator Ratios: Cash Flow Coverage Ratios
  5. Cash Flow Indicator Ratios: Dividend Payout Ratio

Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio

By Richard Loth (Contact | Biography)

The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.

Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency.

The cash flow remaining after this deduction is considered "free" cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company's operating cash flow, the greater the financial strength of the company.

Formula:


Components:


As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had free cash flow of $622.9. We calculated this figure by classifying "additions to instruments" and "additions to property, plant and equipment (PP&E)" as capital expenditures (numerator). Operating cash flow, or "net cash provided by operating activities" (denominator), is recorded at $878.2. All the numbers used in the formula are in the cash flow statement. By dividing, the equation gives us a free cash flow/operating cash flow ratio of 70.9%, which is a very high, beneficial relationship for the company.



Variations:
A more stringent, but realistic, alternative calculation of free cash flow would add the payment of cash dividends to the amount for capital expenditures to be deducted from operating cash flow. This added figure would provide a more conservative free cash flow number. Many analysts consider the outlay for a company's cash dividends just as critical as that for capital expenditures. While a company's board of directors can reduce and/or suspend paying a dividend, the investment community would, most likely, severely punish a company's stock price as a result of such an event.

Commentary:
Numerous studies have confirmed that institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company. In simple terms, the larger the number the better.

Cash Flow Indicator Ratios: Cash Flow Coverage Ratios

  1. Cash Flow Indicator Ratios: Introduction
  2. Cash Flow Indicator Ratios: Operating Cash Flow/Sales Ratio
  3. Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
  4. Cash Flow Indicator Ratios: Cash Flow Coverage Ratios
  5. Cash Flow Indicator Ratios: Dividend Payout Ratio
RELATED TERMS
  1. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  2. Audit

    An unbiased examination and evaluation of the financial statements ...
  3. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  4. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  5. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  6. Selling, General & Administrative Expense - SG&A

    Reported on the income statement, it is the sum of all direct ...
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  5. What is the 'Rule of 72'?

    The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of ... Read Full Answer >>
  6. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center