For businesses of all sizes, keeping a close eye on cash flow is an important part of safeguarding your company’s financial health. There are many ways that you can measure cash flow. At the simplest level, simply comparing your business’s bank account balance with the balance from one month ago will provide a basic cash flow measurement. But there are more sophisticated ways to conduct cash flow analysis, namely: operating cash flow and free cash flow. But what are the differences between these two metrics? Learn more about operating cash flow vs. free cash flow with our comprehensive guide.
What is operating cash flow?
Operating cash flow – also called cash flow from operating activities or cash flow provided by operations – refers to the capital that your business generates through its core business activities. It doesn’t include expenses, revenue drawn from investments, or long-term capital expenditures. In other words, the operating cash flow ratio is entirely focused on your normal business operations.
Operating cash flow is a crucial metric to understand because it tells you whether your business has enough funds to run the company and grow operations. Businesses with a positive operating cash flow, for example, can launch initiatives to fund growth, develop new products and service lines, and pay dividends to shareholders. That wouldn’t be possible with a negative operating cash flow ratio.
How to do an operating cash flow calculation
The formula that businesses use to do an operating cash flow calculation is likely to vary, as different businesses won’t always have the same items on their balance sheet. Generally speaking, however, you can calculate the operating cash flow ratio with the following formula:
Operating Cash Flow = Net Income + Non-Cash Items + Changes in Working Capital
What is free cash flow?
Free cash flow refers to the money that your business generates from its core business activities, after subtracting capital expenditures (i.e. long-term fixed assets like equipment or real estate). In other words, you can think of free cash flow as the amount of cash that your business has left over after accounting for cash outflows that help to expand your assets and support ongoing operations.
Free cash flow is a useful tool for working out not only how effectively your business is able to generate cash from normal business activities, but also how significantly your cash flow is impacted by capital expenditures. Investors and business analysts will often look at free cash flow to work out whether your company has enough money to repay creditors, buyback shares, and issue dividends.
How to calculate free cash flow
Learning how to calculate free cash flow is a relatively simple process, as you simply need to do an operating cash flow calculation and subtract the cost of long-term capital expenditures. This formula can be expressed in the following way:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Is operating cash flow the same as free cash flow?
Now that you know a little more about these financial performance metrics, let’s look at operating cash flow vs. free cash flow. Essentially, the key point of difference between the two metrics is the fact that free cash flow and operating cash flow are a measure of different things. Whereas operating cash flow ratio is solely concerned with the amount of cash generated by your business’s core operating activities, free cash flow looks at how effectively cash from those core operations is generated.
For example, an operating cash flow calculation may indicate that your business has a stockpile of capital from core business activities. However, when you look at the company’s free cash flow, cash outlays may reveal that the business has actually taken on a considerable level of debt, and as such, isn’t in such a strong financial position. When taken together, both metrics should give you a comprehensive understanding of your company’s financial health.
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