How Operating Cash Flow, Capital Spending, and Profit Determine Free Cash Flow
Summary
The document explains free cash flow as operating cash flow after capital expenditures. Operating cash flow reflects cash generated through business operations, while capital expenditures are spending on long-lived operating assets. It distinguishes free cash flow from net income, which is calculated using revenues and expenses and includes items such as interest, taxes, depreciation, and amortization.
A company can raise free cash flow by increasing cash from sales or services, provided capital spending does not rise enough to offset the increase. Cutting capital expenditures can also raise free cash flow in the near term, though investment may be needed to support future growth; ideally, that investment produces a larger increase in operating cash flow. The answer gives a simplified reconciliation from net income to operating cash flow and cautions that company reporting classifications and accounting explanations should be reviewed. It does not analyze Philips’s target or establish a company-specific calculation.
Key ideas
- Free cash flow is operating cash flow minus capital expenditures.
- Free cash flow differs from net income because the measures account for cash flows and expenses differently.
- Higher operating cash flow can increase free cash flow when capital expenditures do not rise as much.
- Reducing capital spending may lift free cash flow, while investment can support future operating cash generation.
- Company reporting policies and disclosures should be reviewed before comparing free cash flow figures.
Tags
Full text
# How does a company increase its free cash flow? # How does a company increase its free cash flow? I am new to the finance space. I read the goal of a company (Philips) is to increase its free cash flow to above 2 billion euros by 2025. I understand that free cash flow is the amount of disposable cash in a business (remaining after all expenditures. Does free cash flow = profit? And how can a company increase its free cash flow? ## Answer by AviatorAlpha (score 1) https://quant.stackexchange.com/a/64066 Firstly, Free Cash Flow (FCF) is the cash flow from operations (which would be sales revenues and service revenues, OCF) after deducting Capital Expenditures (which are long term assets used in operations, CapEx). So to increase free cash flow, increasing operating cash flow by selling more products or providing more services and receiving cash for it would increase operating cash flow, in turn increasing FCF assuming CapEx does not increase. Then reducing CapEx would intuitively increase FCF, but for businesses to grow and increase sales, CapEx is almost a must. Therefore, increase in CapEx would ideally lead to larger increase in OCF, then FCF would increase. Free Cash Flow is not Profit, as profit, known as Net Income, is the net profit from revenue after deducting expenses, interest, taxes, depreciation and amortization. OCF = Net Profit + Depreciation + Amortization + Loss of PP&E - gain on PP&E - Change in Current Assets + change in Current Liabilities. Then from OCF, deduct CapEx to get FCF. I am unsure what accounting standards Philips adheres to, so I cannot state the exact way their OCF and CapEx is derived, as under their Management Decisions & Analysis in the annual report they should provide some sort of clarification. Do note that each company has their way of classifying accounts to make their statements reflect what management wants to show, which are still in accordance to the accounting standards so long as they remain consistent every period, so the MD&A portion needs to be understood to make meaningful sense of the numbers. The above terms and equations are textbook material, which I used, from Financial Accounting, 5th Edition by Spiceland, Hermann, Thomas.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.