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Operating Cash Flow VS Free Cash Flow

Operating Cash Flow VS Free Cash Flow

In this article we’re going to take a look at operating cash flow which is one of the most critical numbers in a company’s accounts many investors pay a great deal of attention to working cash flow as it gives vital clues to an investor trying to assess the health and value of a company so what is it well it’s.

What is Operating Cash Flow

Merely the amount of cash that the company generates from its regular operations. For example, if you are a retailer like Walmart or Debenhams, the bulk of your operating cash flow will come from the difference between the sale price of an item and how much it costs you to sell it.

Amazon Operating Cash flow

The operating cash flow shares many similarities with EBITDA that’s earnings before interest taxes depreciation and amortization. and typically these numbers are not hugely different that’s why I say they’re very similar the difference is due to working capital I can’t assume, you know what working capital is you’ll find that one of the problems with learning and counting is that you have to learn multiple things at once eventually you will piece it all together.

So let’s take a swift look at working capital, we will take working capital to be the difference between current assets, and current liabilities refer to the formula.

Working Capital = Current Assets – Current Liabilities

The word current means that it should be off the company’s books within a year, so an existing asset is something that is expected to be sold or consumed within one year, Let’s see the formula for operating cash flow.

Operating Cash flow Formula

So, operating cash flow equals the net income plus non-cash expenses. It is typically depreciation and amortization mainly let’s add our power of EBITDA plus changes in working capital, so that’s the fundamental formula for operating cash flow.

Operating Cashflow = Net income +Non Cash expenses – increase in working capital

So let’s look at some applications and how operating cash flow is useful to an investor as alluded.

Application Of Operating Cash Flow

  • Reveals Dodgy Accounting
  • More Realistic Pictures Of Companies Health
  • Can assess companies need for external financing

In the introduction, working Capital is beneficial; the primary use is that it can reveal dodgy accounting; for example, a company may generate huge profits but very little cash flow. It may indicate a problem. It would help if you were very skeptical about the source of the advantage when it is not backed up by strong cash flows, this is why I say it gives you a more realistic idea of a company’s health.

Consider a retailer that owns its stores. If the property market rockets, the company will report huge profits, but its operation its operating cash flow won’t be massive, so when you go into those numbers and analyze them, you’ll see that the core business is not nearly as profitable.

As the overall profit figures would indicate, So the other thing you need to be aware of is that a company’s cash flow. What used to expand its business, So a company that is not generating much cash flow will need to get its expansion capital from somewhere else? You can’t just believe the cash flow statement. There are tricks that companies have used to make their numbers bigger the classic one is extending the time taken to pay suppliers.

While collecting the money that’s owed to you faster you see how that would increase the operating cash flow think of it you’re bringing in money faster and paying out slower it’s really a farce but it gives the illusion of higher operating cash flow, so hopefully, you understand the basic ideas of operating cash flow.

Types Of Cash Flow

 

There are generally two types of cash flow, one is negative cash flow, and another one is positive cash flow. I’ll explain to you both in detail.

Negative Cash Flow

If you want to understand any types of cash flow, first of all, you have to follow the meaning g of assets and the liabilities.

 

Assets: which puts money in your pocket

For example, Rent comes from tenants, your business, shares, Bonds. It could be anything.

Liabilities: Which take out money from your pocket

For example, Monthly EMI, Loan, your monthly expenses, house rent, etc

Let’s make it easy with the help of a diagram

If you increase your assets, it will put money in your pocket and increases your income. On the other hand, if you increase liabilities, it takes out money from your pocket, which decreases your revenue.

So, negative cash flow means Your liabilities are more than your assets, which makes you financially weak.

 

Positive Cash Flow

Now, you understand the negative cash flow, so understanding this one is a cup of tea. Positive cash flow is just the opposite of negative cash flow if you increase your asset column which puts regular income in your pocket is known as positive cash flow, Now explain this with the help of a diagram.

 

If you regularly increase your cash flow from assets and keep your expenses financially weak. Low then you have a positive cash flow, which makes you productive.

Free Cash Flow

This is the rule one, investing time we’re going to talk about free cash flow today now free cash flow is incredibly important to a rule one investor this is probably the most critical thing we can look at and interestingly it’s not a number you can come up with very quickly, it’s not part of generally accepted accounting principles.

So, companies, when they form their financial statements, don’t have a line on there for free cash flow and yet this is a number you’ve got to know before you go out there and you buy companies because free cash flow is what you would actually get back in your pocket, if you own the whole company and you get to collect the money then it is Okay.

So, Let’s understand with an example,

You own a laundromat, and you’re going to have to replace washing machines from time to time, So what happens is you get in all this money and then you got to pay off this money to return the tools and stay in business. Now what you’ve got left after you pay your employees, pay for the new washing machines, pay for all your detergent clean the place, pay for your Rent what you’ve got left after you replace everything you need to do to stay in business.

What you’ve got left is free cash flow now interestingly there are lots of businesses that have excellent earnings they’ve got net earnings but they don’t have any free cash flow they chew up all of their incomes just to stay in business, because they have got to rebuild their plant they got to go put stuff back that, they burned up, in fact, the car companies are perfect examples of companies.

There was much trouble getting free cash flow because they continuously have to put in new moles that council got anymore our ID constant got to build the next model. You destroy the old model they got to make new warehouses they got to build new plants, and all of that sucks up free cash flow now free cash flow is hugely important for two reasons.

The first is that’s the money we’d get if we own the whole company that we can then allocate anywhere we want, and second, it’s the money that the company can allocate where it wants as well.

Operating Cash Flow VS Free Cash Flow

Operating cash flow and Free cash flow, why it’s important to you the investor when you’re investing in a company privately or publicly through the stock market. It’s essential to consider what the company’s historical free cash flow and operating cash flow usually is when you’re reading a paper or hearing a news story they’re quoting the company’s quarterly or annual revenues tale. You know it could be very applicable to your investment decision, but it might be a little bit skewed because of potential aggressive accounting practices by the organization.

This may or may not be happening, in either case, it’s good to take a look at what the company’s free cash flow is because it gives you a more accurate picture of what’s going on in terms of actual cash coming in to the company, but if you take a step back from that and look at operating cash flow it gives you an even clearer picture at times.

Where free cash flow and operating cash flow separate operating cash flow is not going to take in any capital expenditure that’s going on whether it’s a property or any company there are capital expenditures aren’t going to look be looked at as a negative in terms of operating cash flow free cash flow though it’s going to take out of free cash flow.

So, therefore, you know you have this property here; you have one quarter you know the revenues or the free cash flow is whatever it is, and then you have the next quarter. You see a drop in free cash flow because this project went on well. If this project makes financial sense, you don’t want to say oh the free cash flow dropped something must be wrong with the business. you want to actually look at operating cash flow and see that no real cash flow is remaining constant or improving or whatever the case, maybe it’s just there was a capital expenditure for a financially, you know sound or financially smart move and therefore operating cash flow becomes a more sensible way to gauge the performance of the business.

Cash Flow Vs Profit

One of the biggest mistakes done by people is the assumed profit as cash flow, they have a big misconception on cash flow, and this reason is enough to make them financially weak. But you don’t need to take worry about it, because I’m here and I’ll tell you what actual cash flow is.

Profit is a short term let’s understand with an example, If you have any capital gain which is not regular because you don’t get capital on a daily basis, but if you have an income coming from tenants it means it is cash flow because tenants give you rent in each month and you receive money from them.

 

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