Cash Flow vs Free Cash Flow

Differences Between Cash Flow and Free Cash Flow

The difference between cash flow vs. free cash flow is havoc. One is used to find out how much cash comes into a business and how much cash goes out at the end of a period. Another is used to find out the valuation of the company through a Discounted Cash Flow (DCF) method.

Cash flow is much broader in concept. And free cash flow is calculated by using earnings before interest and taxes.

As an investor, you need to know them both. Cash flow will help you see the real picture of an organization. And free cash flow will help you find the value of the stock (or the business) by using the DCF method of valuation.

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Cash Flow vs. Free Cash Flow [Infographics]

The differences between cash flow and free cash flow are as follows –

Cash Flow vs Free Cash Flow

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What is Cash Flow?

The cash flow statement is one of the most important statements investors should go through before he ever buys the stock of a company. In the income statement, there’s an opportunity to flatten the profit for the year. But in the cash flow statement, it’s pretty tough to manipulate the numbers.

That’s why, as an investor, your due diligence isn’t complete unless you look at the cash flow statement first.

There are two ways through which you can calculate the net cash flow of the organization – the indirect method and the direct method.

The only difference between direct and indirect method is the calculation of operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more. So first, we will look at cash flow from operating activities, and then we will look at cash flow from financing activities and cash flow from investing activities.

Cash flow from operating activities

First, we will calculate the cash flow operating activities from the indirect method since this is the most preferred method for an organization to calculate cash flow from operations.

In the indirect method of cash flow analysis, the following things should be kept in mind –

Do check out this comprehensive guide to Cash Flow from Operating ActivitiesCash Flow From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more

Here’s an example to illustrate that –

Company XYZ – Cash Flow from Operating Activities (Indirect Method)
DetailsIn US $
Net Income100,000
Adjustments: 
Depreciation & amortization7,000
Deferred TaxesDeferred TaxesDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more600
A decrease in Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more2,300
Increase in Inventories(8,700)
Increase in Account PayablesAccount PayablesAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more800
Increase in Accrued Interest Payable1,600
Loss on Sale of Property1,000
Net Cash Flow from Operating Activities99,400

Cash flow from investing activities

Other than operations, organizations also invest in other assets. That’s why we need to calculate the cash flow from investing activities as well –

  • We need to first add back all the losses incurred on the selling of long term assets.
  • And next, we need to deduct any gains we may have made on the selling of any long term asset.

Do check out this comprehensive guide to Cash Flow from InvestingCash Flow From InvestingCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more

Here’s an example to illustrate that –

Company DEF – Cash Flow from Investing Activities
DetailsIn US $
Net Cash Flow from Operating Activities100,000
Purchase of Plant(64,000)
Cash from Sale of Land24,000
Net Cash Flow from Investing Activities60,000

Cash flow from financing activities

In cash flow from financing activities, we will consider the following –

  • Buying back of stocks and borrowing and repaying loans on short term / long term loans should be included in cash flow from financing activities.
  • We will also take dividends paid into the account.

Do check out this comprehensive guide to Cash Flow from Finance

Now, let’s have a look at the example –

Company DEF – Cash Flow from Financing Activities
DetailsIn US $
Net Cash Flow from Investing Activities60,000
Cash DividendCash DividendCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer.read more(4,400)
Issue of Preferred Shares50,000
Sale of Bonds5,800
Net Cash Flow from Financing Activities111,400

Also, check out the Cash Flow Analysis GuideCash Flow Analysis GuideCash flow analysis refers to examining or analyzing the company's different cash inflows and outflows during the period under consideration from the various activities, including operating activities, investing activities, and financing activities.read more

What is Free Cash Flow?

In this section, we will look at how we can calculate cash flow and also how we use free cash flow in the DCF method.

How to calculate free cash flow?

This is of utmost importance because then only we would under how free cash flow is relevant in calculating the valuation of a business.

Let’s look at the formula first –

Free Cash Flow (FCF) = EBIT * (1 – Tax Rate) + Depreciation – Capital Expenditure – Increase in Net Working Capital / (+) Decrease in Net Working Capital*

*Note: Here, net working capital would be calculatedNet Working Capital Would Be CalculatedThe change in net working capital of a firm from one accounting period to the next is referred to as the change in net working capital. It is calculated to ensure that the firm maintains sufficient working capital in each accounting period so that there is no shortage of funds or that funds do not sit idle in the future.read more by going into the cash flow from operating activities and doing the adjustments regarding current assets and current liabilities.

For further details, please check out this detailed guide on Free Cash Flow to the Firm.

Now, we will look at an example to illustrate FCFFCFThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more.

Company XYZ has the following information –

  • EBIT = $240,000
  • Tax Rate = 33.33%
  • Depreciation = $2400
  • Capital Expenditure = $11,000
  • Increase in Net Working Capital = $6,500

Using the formula above, we get the following result.

  • FCF = $240,000 * (1 – 0.3333) + $2,400 – $11,000 – $6,500
  • FCF = $240,000 * 0.6667 + $2,400 – $11,000 – $6,500
  • FCF = $160,000 + $2,400 – $11,000 – $6,500
  • FCF = $144,900.

How is Free Cash Flow relevant in the computation of valuation under the DCF Method?

Free cash flow (FCF) is calculated so that under the DCF method, we can use FCF. Here’s the formula under the DCF method –

Share Price = ((PV of FCF) + Cash – Debt )/ Shares Outstanding

Here, FCF = Free Cash Flow and PV = Present Value.

Now, we will take an example to illustrate the DCF method.

Company ABC has the following information furnished for us –

  • Free Cash Flow = $150,000
  • Cash = $15,000
  • Debt = $75,000
  • Number of outstanding shares = 40,000
  • WACC = 12%
  • Growth Rate = 4%

We need to calculate the share price using the above information under the DCF method.

Let’s look at the formula under the DCF method once again –

Share Price = ((PV of FCF) + Cash – Debt) / Shares Outstanding

Now we will put the figures from the example in the above formula.

Before that, we need to understand what PV of FCF is.

PV of FCF = FCF / (WACC – Growth Rate)

For more details on the above formula, please have a look at this guide on Terminal Value CalculationTerminal Value CalculationThe terminal value formula helps in estimating the value of a business beyond the explicit forecast period. It includes the value of all cash flows, regardless of duration, and is an important component of the discounted cash flow model (DCF).read more

Where the growth rate isn’t available, we would only use the weighted average cost of capital to discount the FCF.

Let’s put the figures now –

  • Share Price = [($150,000 / 0.12 – 0.04) + $15,000 – $75,000] / 40,000
  • Share Price = [($150,000 / 0.08) + $15,000 – $75,000] / 40,000
  • Share Price = [$18, 75,000 + $15,000 – $75,000] / 40,000
  • Share Price = $18, 15,000 / 40,000
  • Share Price = $45.38

Relevance of free cash flow to the investors

Other than using for the DCF method, FCF is also a great measure of the financial performance of a company.

Free cash flow is the cash a company is able to generate after maintaining or expanding the asset base of the company. If one company has more free cash flow, that means it has more liquidity even after maintaining or spending cash on its assets. But it can also mean that the cash is under-utilized and can be invested in the acquisition of new assets.

That’s why it’s important to look at the holistic picture before trying to interpret the free cash flow of any company.

Key differences – Cash Flow vs. Free Cash Flow

The differences between cash flow vs. free cash flow are as follows –

Cash Flow vs. Free Cash Flow (Comparison Table)

Basis for Comparison – Cash FlowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more vs. Free Cash FlowCash FlowFree Cash Flow
1.    DefinitionCash flow finds out the net cash inflow of operating, investing, and financing activities of the business.Free cash flow is used to find out the present value of the business.
2.    Objective The main objective is to find out the actual net cash inflow of the business.The main objective is to find out the valuation of a business for investors.
3.    ScopeThe scope of cash flow is much broader.The scope of free cash flow is limited.
4.    EquationCash Flow = Cash flow from (Operating activities + Investing Activities + Financing Activities)Free Cash Flow = EBIT * (1 – Tax Rate) + Depreciation – Capital Expenditure – Increase in Net Working Capital / (+) Decrease in Net Working Capital
5.    ComplexityPreparation of cash flow gets complex when multiple cash and non-cash transactions take place during a year.Preparation of free cash flow becomes complex when we need to calculate everything before applying the formula.
6.    Time consumptionCash flow takes a reasonable time to prepare.If all the information is available, FCF doesn’t take a lot of time to calculate.
7.    Key conceptsOperating Cash Flow, Investing Cash Flow, & Financing Cash FlowEBIT, Capital Expenditure, and Increase/decrease in net working capital.
8.    Where is it used?Cash flow is one of the four most important financial statements in financial accounting.Free Cash Flow is used to calculate the valuation under the DCF Method.
9.    SourceTo create a cash flow analysis, an income statement is required.To calculate free cash flow, the income statement is required as well.

Conclusion

Cash flow and free cash flow may seem like similar concepts, but they are completely different.

The basic difference is the way they’re used. One is used to gaze the viability of a business. Another is used to find out the valuation of a business before investing.

As an investor, you need to look at both of them to have a holistic picture of the business. But if you compare cash flow and free cash flow in terms of importance, cash flow analysis should be your first preference. Because after ascertaining the net cash flow from the cash flow statement, you can always calculate free cash flow from there!

Cash Flow vs. Free Cash Flow Video

 

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