by Cash Flow
Cash flow refers to the movement of money into and out of a business or individual’s bank account. It is the net amount of cash and cash equivalents (such as bank deposits and short-term investments) that flow in and out of a business or individual’s account during a specific period of time. Cash inflows refer to the money received by the business or individual, while cash outflows refer to the money spent or paid out by them.
In a business context, cash flow is an essential metric for financial planning and management. It helps businesses determine their ability to meet their financial obligations, such as paying their bills, servicing their debts, and investing in new opportunities. A positive cash flow indicates that a business has more cash coming in than going out, while a negative cash flow indicates the opposite.
Managing cash flow is critical for businesses, as poor cash flow management can lead to insolvency, inability to pay bills, and even bankruptcy. Businesses can manage their cash flow by closely monitoring their income and expenses, implementing efficient billing and collection systems, and keeping a healthy level of cash reserves.
Cash Flow calculations with formula
There are several different ways to calculate cash flow, depending on the specific context and purpose of the calculation. Here are some of the most common formulas for calculating cash flow:
- Operating Cash Flow (OCF) Formula:
Operating Cash Flow (OCF) = Net Income + Non-Cash Expenses – Changes in Working Capital
where:
- Net Income = Total revenue – Total expenses
- Non-Cash Expenses = Depreciation + Amortization
- Changes in Working Capital = (Current Assets – Current Liabilities) current period – (Current Assets – Current Liabilities) previous period
- Free Cash Flow (FCF) Formula:
Free Cash Flow (FCF) = Operating Cash Flow – Capital Expenditures
where:
- Operating Cash Flow is calculated using the formula mentioned above
- Capital Expenditures = the amount spent on purchasing or improving long-term assets, such as property, plant, and equipment.
- Cash Flow from Financing Formula:
Cash Flow from Financing = Cash Inflow from Financing Activities – Cash Outflow from Financing Activities
where:
- Cash Inflow from Financing Activities includes cash received from activities such as issuing bonds, taking out loans, or issuing new shares of stock.
- Cash Outflow from Financing Activities includes cash spent on activities such as paying back loans, paying dividends, or buying back shares of stock.
- Cash Flow from Investing Formula:
Cash Flow from Investing = Cash Inflow from Investing Activities – Cash Outflow from Investing Activities
where:
- Cash Inflow from Investing Activities includes cash received from activities such as selling property, plant, and equipment or investments in other companies.
- Cash Outflow from Investing Activities includes cash spent on activities such as purchasing property, plant, and equipment or investments in other companies.
Free Cash Flow
Free cash flow (FCF) is a financial metric used to measure the cash generated by a company after accounting for the capital expenditures necessary to maintain or expand its business. In other words, it is the cash that a company has available for distribution to investors, debt reduction, or investment in growth opportunities.
To calculate free cash flow, a company starts with its operating cash flow (OCF), which is the cash generated by its operations. This includes cash received from customers, cash paid to suppliers, and other operating cash flows. From this amount, the company subtracts its capital expenditures (CAPEX), which are the investments made in property, plant, and equipment, and other long-term assets necessary to maintain or expand its business.
The formula for calculating free cash flow is as follows:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
If the resulting number is positive, the company has generated free cash flow, which can be used for various purposes, such as paying dividends, repurchasing shares, reducing debt, or investing in growth opportunities. If the number is negative, the company has consumed cash, and may need to raise additional funds through debt or equity financing.
Free cash flow is an important metric for investors and analysts, as it provides insight into a company’s ability to generate cash after accounting for necessary capital expenditures. Companies with positive and growing free cash flow are generally considered to be in a better financial position than those with negative or declining free cash flow. However, free cash flow should be considered in conjunction with other financial metrics, such as earnings, revenue growth, and debt levels, to gain a comprehensive understanding of a company’s financial health.
Free Cash Flow calculations with formula
Free Cash Flow (FCF) is calculated by subtracting capital expenditures (CapEx) from operating cash flow (OCF):
FCF = OCF – CapEx
where:
- OCF (Operating Cash Flow) is calculated as Net Income + Depreciation & Amortization – Changes in Working Capital.
- CapEx (Capital Expenditures) refers to the amount of money spent on long-term assets such as property, plant, and equipment.
Here is the breakdown of each component of the formula:
- Net Income: This is the company’s total revenue minus all of its expenses, including taxes and interest payments.
- Depreciation & Amortization: These are non-cash expenses that represent the reduction in value of the company’s long-term assets over time.
- Changes in Working Capital: This refers to the change in the company’s current assets and liabilities from one period to another, such as changes in accounts receivable, accounts payable, and inventory levels.
- CapEx: This is the amount of money spent on purchasing or improving long-term assets, such as property, plant, and equipment.
By subtracting capital expenditures from operating cash flow, we get the free cash flow available to the company for other purposes such as paying dividends, buying back shares, or investing in new projects.
It’s worth noting that different sources may use slightly different formulas or definitions for free cash flow. It’s important to ensure that you are using the appropriate formula for your specific context and purpose.
Key Differences Between Cash Flow and Free Cash Flow
| Key Differences | Cash Flow | Free Cash Flow |
| Definition | Cash flow refers to the total amount of cash and cash equivalents that flow in and out of a company over a given period of time. | Free cash flow refers to the amount of cash a company generates after accounting for capital expenditures necessary to maintain or expand its business. |
| Calculation | Cash flow is calculated by subtracting cash outflows from cash inflows. | Free cash flow is calculated by subtracting capital expenditures from operating cash flow. |
| Purpose | Cash flow is used to assess a company’s ability to generate cash from its operations, investments, and financing activities. | Free cash flow is used to assess a company’s ability to generate cash after accounting for capital expenditures. It can be used to assess a company’s ability to pay dividends, invest in growth opportunities, and pay off debt. |
| Limitations | Cash flow does not take into account capital expenditures, which are necessary for a company to maintain or expand its business. | Free cash flow can be volatile and may not be sustainable over the long term. It also does not take into account other factors such as working capital requirements and debt repayments. |
| Usefulness | Cash flow is a useful metric for assessing a company’s liquidity and solvency. | Free cash flow is a useful metric for assessing a company’s financial health and ability to generate cash after accounting for necessary capital expenditures. |
Important Differences Between Cash Flow and Free Cash Flow
- Definition: Cash flow measures the net amount of cash and cash equivalents that flow in and out of a company over a specified period of time. Free cash flow, on the other hand, is the amount of cash a company has left over after deducting capital expenditures from operating cash flow.
- Calculation: Cash flow is calculated by adding back non-cash expenses to net income and adjusting for changes in working capital and investing/financing activities. Free cash flow is calculated by subtracting capital expenditures from operating cash flow.
- Purpose: Cash flow measures a company’s overall cash inflows and outflows for a given period, and helps to assess a company’s liquidity and solvency. Free cash flow, on the other hand, provides an indication of a company’s financial health and its ability to fund growth, pay dividends, and reduce debt.
- Limitations: Cash flow does not take into account the company’s capital expenditures and may not provide a complete picture of a company’s financial health. Free cash flow, on the other hand, can be distorted by changes in working capital and unusual items, such as one-time gains or losses.
- Significance: Cash flow is an important metric for understanding a company’s short-term liquidity and ability to meet its obligations. Free cash flow is a key metric for understanding a company’s long-term financial health and ability to fund growth and investments.
Similarities Between Cash Flow and Free Cash Flow
Cash flow and free cash flow are related financial metrics that are commonly used to evaluate a company’s financial health. Here are some similarities between cash flow and free cash flow:
- Both metrics measure the amount of cash that flows into and out of a company over a given period of time. They provide insights into the company’s ability to generate cash from its operations, investments, and financing activities.
- Both metrics can be used to assess a company’s liquidity and solvency. A company with positive cash flow and free cash flow is typically considered to be in a better financial position than one with negative cash flow and free cash flow.
- Both metrics are calculated based on a company’s financial statements. Cash flow is derived from the company’s statement of cash flows, while free cash flow is calculated by subtracting capital expenditures from operating cash flow.
- Both metrics are important for investors and analysts who want to assess a company’s ability to pay dividends, invest in growth opportunities, and pay off debt.
Laws governing Cash Flow and Free Cash Flow
There are no specific laws that govern cash flow and free cash flow. However, there are accounting standards and financial reporting requirements that dictate how companies report their cash flows and free cash flows.
In the United States, the Financial Accounting Standards Board (FASB) sets accounting standards and rules for public companies. The FASB’s Generally Accepted Accounting Principles (GAAP) require companies to prepare cash flow statements that show the sources and uses of cash for a given period. The cash flow statement categorizes cash inflows and outflows into three main sections: operating activities, investing activities, and financing activities.
Free cash flow is not a required financial statement, but it is a commonly used financial metric that investors and analysts use to evaluate a company’s financial health. Free cash flow is the cash flow available to a company after it has paid all of its expenses and capital expenditures. It can be calculated by subtracting capital expenditures from operating cash flow.
While there are no specific laws governing cash flow and free cash flow, companies are expected to follow GAAP and other financial reporting requirements in order to provide accurate and transparent financial information to investors and other stakeholders. Additionally, companies may be subject to legal and regulatory requirements related to financial reporting and disclosures, depending on their industry and jurisdiction.
