Question

Operating return on assets (OROA) and free cash flow (FCF) are two performance measures. What are the similarities and the differences between these two performance measures.

Free Cash Flow (FCF) and Economic Value Added (EVA) are two performance measures. What are the similarities and differences between these two performance measures?

If a firm dramatically increases their R&D expense late in fiscal year 2018, what will be the impact of this decision on the firm's operating margin, EVA, and its stock price in 2018? Explain.

Answer 1

Operating cash flow measures cash generated by a company's business operations.

Free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures.

Operating cash flow tells investors whether a company has enough cash flow to pay their bills.

Free cash flow tells investors and creditors that there's enough cash remaining to pay back creditors, pay dividends, and buyback shares.

Operating return on assets (OROA)

Operating cash flow is an important metric because it shows investors whether or not a company has enough funds coming in to pay its bills or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long-term.

Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a company's cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.

Limitations of Operating Cash Flow

However, there are limitations to using operating cash flow as a cash flow metric. It is important to determine the source of a company's cash flow. For example, a company might increase its cash flow for the quarter because it sold assets, such as equipment. In other words, a company with increasing cash flow isn't necessarily more profitable, nor does it mean that the company's sales or revenues increased.

Also, a company that generated a large sale from a client would lead to a boost in revenue and earnings. However, the additional revenue doesn't necessarily improve cash flow. For example, if the company had difficulty collecting the payment from the customer, operating cash flow would be negatively impacted.

That's why it's important for investors to analyze the inflows and outflows of operating cash flow and determine where the money is coming from and where the money is going.

Free Cash Flow

For investors, there is no set number listed on a company's financial statements that's States the exact amount of cash that they would receive for owning the company's stock. Free cash flow represents the cash flow that is available to all investors before cash is paid out to make debt payments, dividends, or share repurchases.

Free cash flow is typically calculated as a company's operating cash flow after subtracting any capital purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets, including property, buildings, or equipment. In other words, free cash flow helps investors determine how well a company generates cash from operations but also how much cash is impacted by capital expenditures. Free cash flow can be envisioned as cash left after the financing of projects to maintain or expand the asset base.

Free cash flow is a measure of financial performance, similar to earnings, and its use is considered to be one of the non-Generally Accepted Accounting Principles (GAAP).