Question

1. Explain the difference between a company's operating cash flow and its free cash flow. Describe the key features of the free cash flow approach to valuation. 2. What does the phrase sustainable earnings mean? What types of earnings are not sustainable? 3. What are abnormal earnings? Describe the key features of the abnormal earnings approach to valuation.

Answer 1

Answer(1): Difference between a company's operating cash flow and its free cash flow:

S.no	Operating cash flow	Free cash flow
1	It is the cash generated by company's day to day operations in normal course.	It represents the cash, generated after taking into consideration the capital expenditures.
2	Formula: OCF = Net Income+ Non cash expenses - Increase in working capital	FCF = Operating cash flow - Capital expenditures
3	It is measure of operating performance of the company.	It is measure of financial performance of the company.

Answer(2): Key features of the free cash flow approach to valuation-

Free cash flow measures the financial performance of the company. It represents the cash flow from operations after deducting capital expenditures. It shows the net cash left after paying operating and capital expenses.

People use free cash flow method to evaluate the adequate position in the company after paying all type of expenditures. It evaluates the company's position to meet its day to day expenditures and short term cash needs. It takes into account the "Capital expenditures" that are very important to know company's operating efficiency.

Formula: FCF = Net Income + Non cash expenses - Change in working capital - Capital expenditures

Answer(3): Sustainable earnings: Earnings that have effect of after tax of all material. It is the earning, reported after giving effect of tax of all the items. Non recurring expenses, loss and gain are removed.