Cash Flow vs 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.

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

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 activities. 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 –

• First, you need to look at the income statement and pick up “net income” to begin the computation.
• Then, you would add back all the non-cash expenses like depreciation, amortization, etc. As these are not cash expenses, they should be added back.
• Next, we will look at the sale of the assets. If there’s any loss on the sale of the assets, the amount of loss should be added back, and if there’s any gain on the sale of the assets, the amount of gain should be deducted.
• Next, if there’s any change in “non-current” assets, we should make the right adjustments.
• At last, we will make the necessary changes in the current assets and in the current liabilities.

Do check out this comprehensive guide to Cash Flow from Operating Activities

Here’s an example to illustrate that –

Company XYZ - Cash Flow from Operating Activities (Indirect Method)

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 Investing

Here’s an example to illustrate that –

Company DEF - Cash Flow from Investing Activities

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

Also, check out the Cash Flow Analysis Guide

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 calculated 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 FCF.

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 Calculation

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 = / 40,000
• Share Price = / 40,000
• Share Price = / 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.

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

• Cash flow is a much broader concept than free cash flow. The usefulness of free cash flow is limited; whereas, the usefulness of cash flow is all-pervasive.
• The cash flow statement is one of the most important four financial statements in financial accounting. Free cash flow, on the other hand, gets calculated with the help of the cash flow statement.
• The cash flow statement doesn’t only ascertain the operating cash flow. It also pays similar attention to investing and financing activities. Free cash flow, on the other hand, only talks about how much liquidity a company is left with after maintaining or spending on the company’s asset base.
• Both cash flow and free cash flow is calculated by taking help from the income statement. The indirect method of cash flow starts from Net Income, and the direct method of cash flows starts with Sales of the company. On the other hand, the computation of free cash flow is done by taking EBIT (Earnings before interest & taxes) into account.
• Without knowing the changes in working capital, free cash flow can’t be calculated. If there’s no change in the working capital, then only capex and depreciation will be taken into account. In the case of cash flow, it’s not required to know the changes in working capital if the cash flow from operating activities is calculated using the direct method.
• The preparation of the cash flow statement is very complex and arduous. On the other hand, free cash flow can be calculated easily.

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!