Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.
Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company’s competitiveness and efficiency.
The cash flow remaining after this deduction is considered “free” cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company’s operating cash flow, the greater the financial strength of the company.
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had free cash flow of $622.9. We calculated this figure by classifying “additions to instruments” and “additions to property, plant and equipment (PP&E)” as capital expenditures (numerator). Operating cash flow, or “net cash provided by operating activities” (denominator), is recorded at $878.2. All the numbers used in the formula are in the cash flow statement. By dividing, the equation gives us a free cash flow/operating cash flow ratio of 70.9%, which is a very high, beneficial relationship for the company.
A more stringent, but realistic, alternative calculation of free cash flow would add the payment of cash dividends to the amount for capital expenditures to be deducted from operating cash flow. This added figure would provide a more conservative free cash flow number. Many analysts consider the outlay for a company’s cash dividends just as critical as that for capital expenditures. While a company’s board of directors can reduce and/or suspend paying a dividend, the investment community would, most likely, severely punish a company’s stock price as a result of such an event.
Numerous studies have confirmed that institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company. In simple terms, the larger the number the better.