CASH FLOW FROM ASSETS
Cash flow from assets involves three components: operating cash flow, capital
spending, and change in net working capital. Operating cash flow refers to the cash flow
that results from the firm’s day-to-day activities of producing and selling. Expenses
associated with the firm’s financing of its assets are not included because they are not
operating expenses.
Some portion of the firm’s cash flow is reinvested in the firm. Capital spending
refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed
assets). Finally, change in net working capital is measured as the net change in current
assets relative to current liabilities for the period being examined and represents the
amount spent on net working capital. The three components of cash flow are examined
in more detail next.
Operating cash flow
To calculate operating cash flow (OCF), we want to calculate revenues minus costs,
but we don’t want to include depreciation because it’s not a cash outflow, and we don’t
want to include interest because it’s a financing expense. We do want to include taxes,
because taxes are, unfortunately, paid in cash.
Operating cash flow is an important number because it tells us, on a very basic
level, whether or not a firm’s cash inflows from its business operations are sufficient to
cover its everyday cash outflows. For this reason, a negative operating cash flow is often
a sign of trouble.
Capital spending
Net capital spending is just money spent on fixed assets less money received from
the sale of fixed assets.
Change in net working capital
In addition to investing in fixed assets, a firm will also invest in current assets.
A note on “free” cash flow
Cash flow from assets sometimes goes by a different name, free cash flow. Of
course, there is no such thing as “free” cash (we wish!). Instead, the name refers to cash
that the firm is free to distribute to creditors and stockholders because it is not needed
for working capital or fixed asset investments. We will stick with “cash flow from assets”
as our label for this important concept because, in practice, there is some variation in
exactly how free cash flow is computed; different users calculate it in different ways.
Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that
what is being discussed is cash flow from assets or something quite similar.
Cash flow to creditors and stockholders
The cash flows to creditors and stockholders represent the net payments to
creditors and owners during the year. Their calculation is similar to that of cash flow from
assets. Cash flow to creditors is interest paid less net new borrowing; cash flow to
stockholders is dividends paid less net new equity raised.
