Cash flow and free cash flow are both important financial metrics used to determine the liquidity of a company. However, there are distinct differences between the two that allows investors to see how a company is generating cash and how it's spending it.
Cash flow is the net amount of cash and cash equivalents being transferred into and out of a company. Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders and pay expenses. Cash flow is reported on the cash flow statement, which contains three sections detailing activities. Those three sections are cash flow from operating activities, investing activities and financing activities.
Free Cash Flow
Free cash flow (FCF) is the cash a company produces through its operations after subtracting any outlays of cash for investment in fixed assets like property, plant, and equipment. In other words, free cash flow or FCF is the cash left over after a company has paid its operating expenses and capital expenditures.
Free cash flow shows a company's ability to generate cash above its operating and investing needs. Free cash flow is used to measure whether a company has enough cash, after funding operations and capital expenditures, to pay its creditors and equity investors through debt repayments, dividends and share buybacks. To calculate FCF, we would subtract capital expenditures from cash flow from operations.
Comparing Cash Flow to Free Cash Flow
To further illustrate the differences between cash flow and free cash flow, we'll look at an example. Below is the quarterly cash flow statement for Exxon Mobil Corporation (XOM) for the first quarter of March 2018.
- Exxon had $4.125 billion in cash flow for the quarter (in green at the bottom of the statement).
- The total cash flow includes the net amount of debits and credits for cash activities in all three sections of the statement (operating, investing, and financing).
Free Cash Flow
- Exxon had $8.519 billion in operating cash flow (in blue).
- The company also invested in a new plant and equipment, purchasing $3.349 billion in assets (in red). The purchase is a cash outlay.
- The free cash flow for Exxon was $5.17 billion for the period ($8.519 billion minus $3.349 billion).
In the above example, total cash flow was less than free cash flow partly because of reductions in the short-term debt of $3.872 billion, listed under the financing activities section. Cash outlays for dividends totaling $5.742 billion also reduced the total cash flow for the company.
By comparing cash flow to free cash flow, investors can gain a better understanding of where cash is coming from and how the company is spending its cash. For example, a company may have a stockpile of cash; at first glance, that may appear to be a good sign. However, under closer inspection, we might uncover that the company has taken on a sizable amount of debt that it does not have the cash flow to service.
By analyzing both cash flow and free cash flow, we can see how much a company generates from their normal course of operations, what they're investing in and how much debt they're paying down or taking on. As a result, investors can make a more informed decision as to the financial viability of the company and its ability to pay dividends or repurchase shares in the upcoming quarters.