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
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RELATED FAQS
  1. What's the difference between free cash flow and operating cash flow?

    Learn the difference between free cash flow and operating cash flow. Explore how analysts use earnings and cash flow when ... Read Answer >>
  2. What is the difference between cash flow and free cash flow?

    Learn about the main differences between cash flow and free cash flow. In addition to the differences, learn how to calculate ... Read Answer >>
  3. What is the formula for calculating free cash flow?

    Read about some of the formulas for free cash flow, why investors perform cash flow analysis and what a high or rising cash ... Read Answer >>
  4. Is free cash flow the same as net free cash flow?

    Know the difference between your net cash flow and free cash flow when pitching your company to any of your potential stockholders. Read Answer >>
  5. Are taxes calculated in operating cash flow?

    Learn how taxes are involved with the calculations for operating cash flow, and find out about the importance of operational ... Read Answer >>
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