How CFOs Evaluate FCF vs OCF (Free Cash Flow vs. Operating Cash Flow)

And to quickly illustrate the difference for you, If a company begins its accounting period with a cash balance, that's right here, typically cash balance fluctuates as you conduct business in a company.

So first maybe you pay your rent, so your cash balance goes down, and then you collect money from customers, and then you pay your payroll, and then you collect again money from customers, and then maybe you buy inventory.

At the end of this cycle, this is what we call operating cash flow.

At the end of the cycle, the net change in cash is what we call operating cash flow.

Now, after that comes CapEx, you buying equipment in the business to reinvest in the business.

This CapEx purchase here, dropping your cash balance, at the end of that, that's what we call free cash flow.

So the result of your operating activity and then CapEx reinvestment in the business That's the net effect of all of that.

We call that free cash flow.

So let's go through an example of that.

If we have a manufacturing company that has operating cash flow of $2 million and have capex of $1.6 million, let's go ahead and calculate free cash flow.

So free cash flow is gonna be your operating cash flow, which is the $2 million, minus your capex, what you spent to reinvest in the business, $1.6 million.

The result of that is 400K.

So 400K is what we refer to as free cash flow, taking your operating cash flow and reducing any capex that you spent to reinvest in the business.

So looking at these numbers on the surface, a controller may look at this and say, well, the operations are healthy.

We're bringing in $2 million in operating cash flow.

This looks great.

The cash is coming in and the business is functioning.

We're able to collect money from our customers, like we said here, pay our rent, payroll, inventory, and all of our obligations.

However, a CFO looks at this and says, we only have 400K.

We don't have the entire $2 million.

We only have 400K in free cash flow that is available to us to reinvest in the business.

So our ability to pay down debt, pay dividends to shareholders, do acquisitions that are strategic for the business is going to be limited to that 400K.

And because growth is expensive and requires reinvesting in the business, a CFO looks at this and says, I have 400K and I need to be careful in how I allocate this capital to reinvest it back in the business.

Okay, so when we look at OCF versus FCF, now we realize why OCF is about liquidity.

It's about cash that's coming in from customers, expenditures that are required to operate the business.