Free Cash Flow Versus Operating Cash Flow

I’ve been writing recently about cash flow, specifically in regards to important ratios to interpret it. The free cash flow to operating cash flow ratio is a useful measurement. Let’s see how it is calculated and what it means.

First Some Definitions

Generally free cash flow (abbreviates as FCF) is considered to be operating cash flow minus capital expenditures. (See Importance of Free Cash Flow)

Operating cash flow (OCF) is calculated as net income adjusted for non-cash charges and changes in current assets and liabilities. (See Operating Cash Flow Defined) In this calculation net income does not show the effect of interest and income taxes, so it is actually earnings before interest and income taxes (Abbreviated EBIT).

Calculating the Free Cash Flow to Operating Cash Flow Ratio

The formula for calculating the free cash flow to operating cash flow ratio, expressed as a percentage is:

FCF to OCF Ratio = Free Cash Flow / Operating Cash Flow

Remember that Free Cash Flow (FCF) = Operating Cash Flow – Capital Expenditures

An Example

Assume a company made capital expenditures during the year of $100,000. Also, assume the following calculation of annual operating cash flow:
calculating operating cash flowUsing the above information we can calculate the free cash flow as:

FCF = $156,815 – $100,000 = $56,815.

Thus the calculation of the free cash flow to operating cash flow ratio would be:

FCF/OCF Ratio = FCF / OCF

FCF/OCF Ratio = $56,815 / $156,815

FCF/OCF Ratio = 36.2%

What It Means

In the example above the ratio is not terrible yet not particularly strong. If the capital expenditure is not something that occurs that often then this lower ratio might be okay for this particular year, On the other hand, if capital expenditures are using a very high amount of operating cash flow in most years, reflected in a relatively low free cash flow to operating cash flow ratio, then this could be a sign that the company is not really generating enough operating cash flow. It could be in danger should a year occur where sales are significantly lower or expenses grow more than anticipated.

Do you understand why this relationship between free cash flow and operating cash flow is important to measure and understand?

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed

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