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

In today's video, we'll discuss how a CFO evaluates operating cash flow versus free cash flow. Operating cash flow is what helps the company keep the lights on, while free cash flow gives the company freedom and choices. And as you'll see in the example that we'll go through, a company could have an amazing operating cash flow but terrible free cash flow. If that sounds good to you, let's jump right in. Hey guys, this is Bill Hanna, your favorite financial controller, with about 20 years of experience in corporate accounting and finance. Today's video is about the difference between OCF and FCF. 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 the 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 going to 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. Free cash flow is about strategic capacity. Like we said, we have $400K leftover after we invested in CapEx. That is our capacity, what is leftover to create freedom and choices in the business, because that's the leftover cash that you can reinvest back in the business. Therefore, the focus of these two metrics is different. The focus with operating cash flow is about operations. Are we managing our operations effectively and efficiently? While the focus with FCF is going to be on value creation, that money that we have left over, how can we use that money to create value in the business? With OCF, the focus is going to be on short-term survival. So I'm thinking, what am I doing with the funds that I have from customers and how I use that to pay my vendors and payroll and my financial obligations? While with free cash flow, we're thinking long-term sustainability, right? So we're thinking, what can we do to reinvest back in the business to create value for shareholders? OCF answers the question, are we liquid? While FCF answers the questions, what can we do with excess cash? We have excess cash. How can we allocate that to better serve the business? Therefore, OCF is often used by controllers and FP&A professionals while free cash flow is often used by CFOs, investors, lenders, board members, because it has strategic nature of trying to figure out how to allocate this free cash flow for future growth. If you would like a summary of all of the stuff that we have here on the whiteboard, I'll leave that PDF attached down below in the description. Go ahead and download the summary of all the things that we're discussing here today. Okay, so we said with CapEx when we look at OCF, CapEx is not included, right? We're not adding CapEx. CapEx is not factored in in OCF. OCF is all about changes to working capital without looking at reinvesting in the business. While with free cash flow, yes, we deduct CapEx because CapEx, when we deduct that, we will know how much money is free for us to use in the business. Therefore, it's more conservative. Free cash flow is more conservative a more realistic measure of available cash. That's why it's so crucial that CFOs and controllers focus on understanding how their OCF works and how their FCF works so that they have more optionality in the business. If you're enjoying this video so far, go ahead and hit that like button because that is the only way for me to know if you enjoy this content and go ahead and share it with someone that you know will benefit from this content. Okay. Now let's look at decision-making. What kind of decisions does OCF versus FCF help us make as CFOs and controllers. Well, with the OCF, it's all operational, right? So are we able to make payroll on time? Do we have enough cash to make vendor payments and how to tweak the vendor payment timing so that we can accommodate the cash that we have? Short-term cash forecasting, right? So this OCF helps us forecast for the next maybe 3 to 6 months the kind of cash balance that we'll have, and that will help us manage working capital. Working capital is defined as current assets minus current liabilities, right? So all of your customer collection, accounts payable, inventory, accrued expenses, all of that falls within your working capital management. The decision-making is more strategic with free cash flow. So for example, debt repayment. If I have a loan, right, so I want to reduce how levered the company is, I can pay back my debt. But to pay back my debt, I need to have Free cash flow. So it's all about options here, uh, dividends and distributions, right? If I have enough cash left over after CapEx, I can pay back shareholders and owners. Mergers and acquisitions. So if we have a target company that we know is going to support our long-term growth, we can only make a move and think about acquiring the company if we have free cash flow. So it's all about long-term investment strategy versus making short-term decisions for the business. Now let's look at what insight do we get from OCF and FCF and how a smart CFO would consider both of them, would consider OCF for operations and FCF for long-term growth. So one example that we have is a company that has high OCF and high FCF. So the operations are great but long-term planning is going to be difficult. So this signals to me that We have strong operations. We're managing our receivables and payable efficiently. We have strong financial flexibility because we have enough leftover after CapEx to reinvest in the business. The second example is a company with a high OCF but low FCF, and this is typically with companies that have a lot of capital-intensive needs, right? You need to reinvest back in the business buying equipment. Think of airline or private jet companies. You need to buy very expensive planes and assets to keep the business running. The same with manufacturing that requires to replenish and buy additional equipment to run the business. You may have high OCF because you're able to run your AP and AR efficiently, but you have low FCF because you keep buying assets to support the running of the business. We have an example of a low OCF. If you have a case where a company has low OCF, low operating cash flow, it just means that the business model itself is difficult. So operating cash flow is defined as net income and then adding back non-cash expenses and changes in working capital. So when you have low OCF, it just means that the core operation of the business is pretty difficult and you need to examine the business model and examine how you're managing your customer collection and accounts payable. Another example is a company with low FCF. Well, this is a company that has a lot of capital needs. And that gives us limited capacity for growth or giving any kind of shareholder return when you have limited FCF or free cash flow. So in summary, a successful CFO or controller will focus on both operating cash flow and free cash flow. Operating cash flow will keep you alive, while free cash flow will give you choices. Choices will give you leverage, and leverage will create long-term value. 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