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

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
Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
RELATED TERMS
  1. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  2. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  3. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  4. Working Capital

    This ratio indicates whether a company has enough short term ...
  5. Promotional CD rate (Bonus CD rate)

    A limited-time offer of a higher rate of return on a certificate ...
  6. Bid Wanted

    An announcement by an investor who holds a security that he or ...
  1. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1994, and how the cost of living has changed above and beyond what can ...
  2. When should I use depreciation expense instead of accumulated depreciation?

    Distinguish differences between depreciation expense, which is reported on the income statement, and accumulated depreciation ...
  3. What are the income statement presentation formats and what industries use them?

    Learn about two styles of income statements: the single-step method and multi-step method. Determine which types of businesses ...
  4. How is impairment loss calculated?

    Learn how companies re-evaluate their assets and compare them against book values to recognize impairment and why this strategy ...
comments powered by Disqus
Related Tutorials
  1. Industry Handbook
    Investing Basics

    Industry Handbook

  2. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Discounted Cash Flow Analysis
    Fundamental Analysis

    Discounted Cash Flow Analysis

  4. Ratio Analysis Tutorial
    Fundamental Analysis

    Ratio Analysis Tutorial

  5. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

Trading Center