Free Cash Flow to Operating Cash Flow Ratio

The free cash flow to operating cash flow ratio is different from other ratios. It is different in the sense that it is comparing two measures of cash flow. Usually cash flow ratios compare a cash flow item to an item on the income statement or on the balance sheet. Here are the details of this ratio:

Defining the Terms

The terms used in the ratio i.e. operating cash flow as well as free cash flow have been described in the cash flow section. But here is a quick refresher.

Operating Cash Flow: Operating cash flow is considered by many to be the most appropriate measure of cash flow. It measures the cash flow that the company has been able to generate from its regular day to day operations. Cash flow generated from onetime events such as sale of assets and investments is not a part of this. Hence investors can expect this cash flow to continue in the next period.

Free Cash Flow: Free cash flow is not listed on the cash flow statement. Rather it is derived by subtracting the capital expenditure from operating cash flow. This measure is important because this is the amount of cash flow that the investors have left after meeting the growth needs of the firm.

Formula

The name of the ratio pretty much gives away the formula. The formula is as follows:

Free Cash Flow to Operating Cash Flow Ratio = Free Cash Flow / Operating Cash Flow

Meaning

This ratio tells the investors about how much free cash flow is being generated for every rupee of operating cash flow. A higher ratio means company is not investing too much in capital expenditure and therefore maybe a mature company that is not seeking any more growth but rather seeking to sustain its operations.

Interpretation

  • Compare With Maturity of the Firm: The stage of maturity of the firm has a huge impact on the free cash flow to operating cash flow ratio. Mature stable firms do not need to make too many capital investments and thus have a higher ratio. On the other hand companies that are growing will have a lower ratio. One needs to start questioning if mature companies have lower ratios or vice versa.

  • Gestation Period: The gestation period is the time that is taken for the capital expenditure to start producing revenues and cash flows. A company with a high gestation period will invest more and more each year, the effects of which will not be visible in the free cash flow to operating cash flow ratio until many years.


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