What Differentiates Free Cash Flows from Cash Flows from Operations?
“Cash flow” is a term that many business owners are used to hearing. The term is used to understand the amount of cash that you have that can be used to invest in the business, pay employees and keep operations going.
However, you should know the difference between:
1. Free cash flows
2. Cash flows from operations
What are free cash flows? What’s the free cash flows formula? What about cash flow from operations?
Cash Flows from Operations
The term cash flows from operations (CFFO) indicates the amount of cash that the business generates only from their traditional business activities. When calculating CFFO, it includes things, such as:
· Revenue from sales
· Expenditures for rent, salary, inventory, etc.
CFFO is present in a business’s cash flow statement and will be reported each quarter and annually. If cash flow from operations falls too low, this is a signal that the business needs to secure outside funding. External financing or investments in the business will be necessary when CFFO remains in the negative or too low to reach growth goals.
Free cash flows are slightly different.
Free Cash Flows
The difference in statement of operations and cash flows is that free cash flows (FCF) indicate how much free cash a business has before interest payments and after capital expenses, such as buying a new building or investing in new equipment.
FCF is an important figure to know, but it’s not without its downside.
In some industries, major capital expenditures are the norm. For example, in the oil industry, businesses will heavily reinvest their cash to purchase new drilling equipment and machines.
What is the difference?
CFFO and FCF are intrinsically different, and the key difference is in what they include in their calculations. For example, CFFO will include money that the business spends on things such as:
· Rent
· Salary
· Etc.
FCF shows investors how much cash the business has before accounting for expenditures, such as paying off debt or paying dividends. Often, FCF will be calculated as the business’s operating cash flow prior to:
· Interest payments
· Capital expenditures
Investors and business stakeholders will examine FCF to have a better understanding of the operation’s ability to generate cash from its operations. Additionally, FCF makes it easier to understand how much the business is spending on larger capital expenses.
CFFO: Why Is It Important?
Cash flow from operations provides insight into a business’s ability to sustain operations. The metric shows investors and stakeholders the ability of the business to continue existing. If CFFO is in the negative, this is a sign that the business is unsustainable and will either need to secure loans and investments or taper operations back to save money.
If CFFO is in the positive, the business will have the opportunity to:
· Reinvest in business operations
· Pay its debts
CFFO is only part of the equation when trying to envision the health of a business. You also need to have the full picture of your expenses, and this means fully understanding the FCF, too.
The importance of FCF
FCF is an important metric that every business owner should know. Since capital expenditures are for long-term, fixed assets, they need to be calculated separately to understand the financial health of a business.
Free cash flows is a good indicator of a business’s ability to:
· Reinvest
· Return dividends to shareholders
However, FCF has less to do with the day-to-day operations of the business than CFFO.
Which one is more significant?
Unfortunately, understanding the financial health of a business demands that both CFFO and FCF are well-known. However, free cash flows is often seen as more accurate because it does include large capital expenditures.
In essence, FCF will provide insights into:
· Cash flow from operations
· Impact of capital expenditure on the business
Many businesses will run with low FCF on paper, but when analyzed, the business may be found to invest heavily in new equipment and expansion. If these major expenses didn’t exist, the remaining CFFO shows how much cash the business would maintain.
Concluding remarks
Even if you know how to calculate free cash flows and CFFO, using software to work through these calculations will help speed up the process. Software will reduce errors in calculations and allow you to immediately see the financial health of your business.
