Free Cash Flow vs. Operating Cash Flow: An Overview

Free cash flow is the cash that a company generates from its normal business operations after subtracting any money spent on capital expenditures. Capital expenditures or CAPEX for short, are purchases of long-term fixed assets, such as property, plant, and equipment. 

On the other hand, operating cash flow is the cash that's generated from normal business operations or activities. Operating cash flow shows whether a company generates enough positive cash flow to run its business and grow its operations.

Free cash flow and operating cash flow are often used as metrics when comparing competitors in the same or comparable industries. Operating cash flow, free cash flow, and earnings are all important metrics when researching and evaluating a company that is being considered for investment.

Key Takeaways

  • Operating cash flow measures cash generated by a company's business operations.
  • Free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures.
  • Operating cash flow tells investors whether a company has enough cash flow to pay their bills.
  • Free cash flow tells investors and creditors that there's enough cash remaining to pay back creditors, pay dividends, and buyback shares.

Operating Cash Flow

Operating cash flow is an important metric because it shows investors whether or not a company has enough funds coming in to pay its bills or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long-term.

Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a company's cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion. 

Limitations of Operating Cash Flow

However, there are limitations to using operating cash flow as a cash flow metric. It is important to determine the source of a company's cash flow. For example, a company might increase its cash flow for the quarter because it sold assets, such as equipment. In other words, a company with increasing cash flow isn't necessarily more profitable, nor does it mean that the company's sales or revenues increased.

Also, a company that generated a large sale from a client would lead to a boost in revenue and earnings. However, the additional revenue doesn't necessarily improve cash flow. For example, if the company had difficulty collecting the payment from the customer, operating cash flow would be negatively impacted.

That's why it's important for investors to analyze the inflows and outflows of operating cash flow and determine where the money is coming from and where the money is going.

Free Cash Flow

For investors, there is no set number listed on a company's financial statements that's States the exact amount of cash that they would receive for owning the company's stock. Free cash flow represents the cash flow that is available to all investors before cash is paid out to make debt payments, dividends, or share repurchases. 

Free cash flow is typically calculated as a company's operating cash flow after subtracting any capital purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets, including property, buildings, or equipment. In other words, free cash flow helps investors determine how well a company generates cash from operations but also how much cash is impacted by capital expenditures. Free cash flow can be envisioned as cash left after the financing of projects to maintain or expand the asset base.

Free cash flow is a measure of financial performance, similar to earnings, and its use is considered to be one of the non-Generally Accepted Accounting Principles (GAAP).

Free Cash Flow and Dividends

The amount of cash flow available is usually used to calculate how likely a company can make its dividend payments. Dividends are cash payments to investors as a reward for owning the stock. If a company is generating free cash flow that exceeds dividend payments, it's likely to be seen as favorable to investors, and it could mean that the company has enough cash to increase the dividend in the future.

Also, investors can take a company's free cash flow figure and subtract the company's interest and debt payments to determine how much cash is remaining to pay for dividends.

Many analysts feel dividend outlays are just as important an expense as capital expenditures. The board of directors of a company may elect to reduce a dividend payment. However, this usually has a negative effect on the stock price, as investors tend to sell holdings in companies that reduce dividends.

Free Cash Flow and Creditors

Free cash flow measures the cash flow available for distribution to all company securities holders, including creditors. Banks that lend to companies want the company to be able to generate free cash flow so that the company is able to pay back the debt.

If a company wanted to borrow an additional amount of money from their bank, the lender would use free cash flow to determine the amount of loan the company could repay. The lender would subtract the current debt payments from free cash flow to determine the amount of cash flow available to pay for additional borrowings.

Limitations of Free Cash Flow

However, there are limitations to free cash flow, including companies that have significant capital purchases. For example, some industries are very capital intensive, such as the oil and gas industry. Oil companies must purchase or invest a significant amount of capital in fixed assets, such as machinery and drilling equipment. As a result, free cash flow can be inconsistent over time since these significant capital outlays of cash are needed. 

It's important that investors compare free cash flow with similar companies or industries. It doesn't make sense to compare the free cash flow of an oil company with the free cash flow of a marketing firm that has no significant capital purchases or fixed assets. 

Companies with positive free cash flow are able to expand their business while those with falling free cash flow might need restructuring or additional financing.

Free Cash Flow vs. Operating Cash Flow Examples

Below is the cash flow statement for Apple Inc. (AAPL) as reported in the company's 10-Q filing for the period ending December 28, 2019.

Operating Cash Flow

At the top of the cash flow statement, we can see that Apple carried over $50.224 billion in cash from the balance sheet and $22.236 billion in net income or profit from the income statement. Once the day-to-day operating expenses are deducted, we arrive at the company's operating cash flow.

Apple recorded $30,516 billion in operating cash flow (highlighted in green). The aggregate amount of operating cash flow included the daily operating activities, such as:

  • Inventory purchases for $28 million
  • Accounts receivables for $2.015 billion, which represents money owed to Apple by its customers for booked sales
  • Accounts payables of $1.089 billion, which is money owed by Apple to its suppliers and vendors

Free Cash Flow

  • Apple invested in a new plant and equipment, purchasing $2.107 billion in assets (in red). The purchase is a cash outlay.
  • We already know that the company's operating cash flow was $30.516 billion.
  • As a result, Apple's free cash flow was $28.409 billion for the period ($30.516 - $2.107).
Examples of operating cash flow and free cash flow using Apple Inc.
Examples of operating cash flow and free cash flow using Apple Inc. Investopedia