How should I look at accounting earnings, operating earnings, and free cash flow?

Before I get to free cash flow, I always compare operating cash flow to earnings. How do they compare? Are they about the same, or very different?

If they are about the same, I know that the various components of GAAP accrual accounting such as amortization and depreciation, stock-based compensation, and working capital are either not significantly affecting the actual operating cash the company makes with respect to accrual earnings or are canceling each other out.

If operating cash flow is significantly less than earnings, I get wary. Why is the actual cash coming into the business less than the accrual accounting earnings? Is accounts receivable building up to dangerous levels? Is accounts payable dropping at a faster percentage than revenue?

If operating cash is much more than accounting earnings, it can many times be a good thing.

For example, a subscription-based service such as Microsoft‘s (Nasdaq: MSFT) service contracts collect cash up front but have to amortize that cash in its accounting earnings across the length of the entire contract. It shows up as a lump sum in the cash flow statement, but just a tiny portion shows up in the earnings statement.

Or perhaps the company has a very large depreciation and amortization charge, like the airlines or even Starbucks (Nasdaq: SBUX). This is money spent in the past on capital expenditures (capex) that is now being regularly charged against earnings on an accrual basis along the length of the life of the asset they spent the capex money on in the first place.

It’s only after looking at operating cash flow that I look at free cash flow, where I subtract capex (and possibly also acquisitions, if the company regularly buys other companies in order to grow, like 3M (NYSE: MMM)). I compare the amount spent on capex to the amount charged to depreciation and amortization. Is it more? Less? About the same?

The amount the company is spending growing and maintaining the company going forward versus the amount they spent growing and maintaining it in the past is helpful in getting an estimate on how fast the company will grow in the future.

The main thing with free cash flow (FCF) is it shows you the actual cash money left in that particular earnings report that is left over after all expenditures have been taken care of. The two main considerations for you as an investor are:

  1. How does FCF compare to the accrual earnings?
  2. How indicative is that FCF figure of the company’s performance going forward?

The advantage of accrual earnings is its main disadvantage: it smooths things out over time. It’s the same with FCF but in reverse. There is no smoothing. So if you calculate FCF based on just one earnings report, you need to make darn sure that the number, while accurate relative to that single earnings report, is a sensible number to base longer-term estimates of value off of.

— Answer provided by Motley Fool member Mike Sandrik

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1 Comment

  1. Richard Hajduk

    It makes look at stocks at a different way. Know how to put a value on the stock..