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Thursday, February 24, 2011

The difference between cash flow and free cash flow

Cash flow represents the flow of money for a specific period of time where as free cash flow indicates a cash flow balance after the flow of cash in and out of accounts. The difference between cash flow and free cash flow is a) when the calculation is made, and b) what the cash flow used for. Both cash flow and free cash flow are important aspects of business activity that can be used to analyze financial activity and performance.

Free cash flow (FCF) often represents the available amount of surplus cash after operating and investing cash flows have been determined. If free cash flow is a positive number, it is more likely to be free cash flow whereas cash flow precedes free cash flow in the sense it is used to pay expenses, and invest as evident on the statement of cash flows.


Definition(s) of cash flow


How one calculates cash flow depends on the activity the cash flow pertains to, and the accounting rules in place which govern the use and recording of cash flow. This is why the cash flow statement is so useful; it provides a picture of what a company has done with its cash over a period of time, for example three months if a quarterly statement.

To illustrate cash flow, an example of  cash flow from investing activities can be used. Cash flow from investing can include sales of investments or investment projects in addition to new investments made are recorded in this aspect of cash flow. To see how cash flow from investing is recorded, reviewing an example example statement of cash flow is demonstrative.

In this example, cash flow from investing activities go into and out of the company. In this particular instance the only two items recorded are $33,600 cash inflow from a sale and investment in property and equipment for $75,000 for a net outflow of $41,400.  A negative cash flow for investing is not necessarily a bad thing as it means the company has money to invest or considers the investment prudent and the company is attempting to grow its financial positioning.

Calculating free cash flow


Free cash flow, unlike cash flow, is more indicative of an ending cash balance after a series of cash flows. The term 'free' in free cash flow illustrates the positive cash flow resulting from a free cash flow calculation is free to use in ways other than those that are pre-allocated for specific use i.e. corporate operations and sustainability.

Free cash flow can be calculated in more than one way, but generally or most commonly subtracts capital expenditures from operating cash flow.(2) Keep in mind this does not  necessarily include all capital expenditures or include cash flow from financing activities which is somewhat separate from a company's daily operations. To include financing activities in a free cash flow calculation another cash flow calculation is used i.e. 'Free cash flow to equity'. (1) Three types of free cash flow are listed below:

1. Free cash flow
2. Free cash flow to equity
3. Unlevered free cash flow

How free cash flow is calculated determines how useful it is as a financial indicator and what it is measuring. For example, the free cash flow to equity calculation provides insight into how financing affects free cash flow by adding borrowed funds to the free cash flow equation. However, this may not accentuate the cost of that cash flow.

Unlevered cash flow demonstrates how much money is available to pay back company debts absent financing and returns on investments and standard free cash flow measures available capital for investing and/or financing new corporate projects.(4)

In light of the standard definition of free cash flow, the definition of capital expenditures becomes particularly relevant. This is because those capital expenditures used to sustain corporate income as distinguished from capital expenditures used to grow corporate revenue and/or income are different thus excluding growth expenditures should be used in the free cash flow calculation if it is to measure free cash flow available for new and expanded investments and expenditures.

Sources:

1. http://peregrin.jmu.edu/~drakepp/general/FCF.pdf (CF and its calculation)
2. http://www.investopedia.com/terms (Cash flow & Free Cash Flow)
3. http://www.allbusiness.com/finance/886781-1.html (Defining FCF)
4. http://www.quickmba.com/finance/free-cash-flow/ (Free cash flow)

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