Cash flow and free cash flow are important financial ratios used to determine liquidity of the company. However, there are some differences between the two that allows investors to see how companies generate cash and how to spend it.
Cash flow is the net amount of cash and cash equivalents to be transferred into and out of the company. Positive cash flow means that the liquid assets of the company are increased, allowing it to pay off debt, reinvest in its business, return cash to shareholders, and to pay the costs. The cash flow reported in the statement of cash flows consists of three sections detailing cash activity. These three sections of the cash flow from operating activities, investment activities and financing activities.
Free Cash Flow
Free cash flow is the cash that the company generates through its operations after deducting all cash expenditures for investments in fixed assets such as property, plant and equipment. In other words, free cash flow or net cash flow is the cash remaining after the company pays its operating expenses and capital expenditures.
Free cash flow shows how effectively a company generates and uses its cash. Free cash flow is used to determine whether the company has enough cash after funding operating and capital costs to pay back investors via dividends and share buybacks. To calculate free cash flow, we would subtract capital expenditures from cash flow from operating activities.
Comparing cash flow free cash flow
To illustrate the differences between cash flow and free cash flow, we will consider an example. Below are presented the quarterly report on cash flows of the Corporation “Exxon Mobil” (SOM) as at 31 March 2018.
- Exxon had $billion of 4.125 in cash flow for the quarter (in green at the bottom of the application).
- The cumulative cash flow includes the net amount of debits and credits for cash activities in all three sections of the report (operating, investing, and financing).
Free Cash Flow
- Exxon already 8.519 billion in operating cash flow (in blue).
- The company has also invested in new plant and equipment purchases of 3.349 billion dollars in assets (in red). Purchase cash outlay.
- Free cash flow for Exxon was $5.17 billion for the period ($8.519 – $3.349).
In the above example, the total cash flow was lower than free cash flow, partly due to the reduction of short-term debt 3.872 billion U.S. dollars, is listed under financing activities. Cash expenditures for payment of dividends in the amount of 5.742 billion dollars and overall cash flow for the company.
By matching cash flow to free cash flow, investors can better understand where cash comes from and how the company spends their money. For example, a company may have cash reserves and, at first glance, it may seem a good sign. However, on closer examination, we may find that the company has undertaken a significant amount of debt that he has no funds for maintenance.
By analyzing cash flow and free cash flow, we see how much the company receives from its normal work that they put in and how much debt they will pay or take. As a result, investors can make a more informed decision regarding the financial stability of the company and its ability to pay dividends or repurchase shares in the coming quarters.
For more on cash flow, please read “what is the formula to calculate free cash flow?”