Earnings vs. Free Cash Flow: CapEx & OpEx Differences

Imagine you are running a lemonade stand. To keep it running smoothly, you have daily costs like buying lemons, sugar, and cups. These are like operating expenses in a real business. They are the regular, day-to-day costs needed to generate your lemonade sales. These expenses are immediately subtracted from your lemonade sales to figure out your daily profit, or what we can relate to as earnings.

Now, suppose you decide your lemonade stand is so popular you need a bigger, sturdier stand. Instead of just a folding table, you invest in a custom-built wooden stand with a fancy sign. This is a significant, one-time investment that’s meant to benefit your business for years to come. This is similar to a capital expenditure for a real company. Capital expenditures are investments in long-term assets that are expected to provide benefits over multiple accounting periods, like buying new equipment, buildings, or technology.

Operating expenses, like the cost of lemons and sugar for your lemonade, are fully expensed in the period they are incurred. This means they directly reduce your earnings in that period. If you spend $10 on lemons and sugar and make $30 in sales, your profit, or earnings, for that day is $20. This is straightforward.

Capital expenditures, however, are treated differently when calculating earnings. Think about your fancy new lemonade stand. It cost you a significant amount of money upfront. But instead of deducting the entire cost of the stand from your earnings in the day you bought it, accountants recognize that the stand will benefit your business for several years. So, they spread out the cost of the stand over its useful life through a process called depreciation. Imagine the stand is expected to last for five years. Instead of deducting the entire cost upfront, you might deduct a portion of the cost, say one-fifth, each year as depreciation expense. This depreciation expense, like operating expenses, reduces your earnings, but it’s just a fraction of the initial cash outlay and is spread over time.

Now, let’s talk about incremental free cash flow. Free cash flow is all about the actual cash a business generates after accounting for the money it spends to maintain or expand its asset base. Incremental free cash flow focuses on the change in free cash flow resulting from a specific decision or project, like expanding your lemonade stand business to a second location.

When calculating incremental free cash flow, we are concerned with the actual cash inflows and outflows. Operating expenses are cash outflows, and they directly reduce free cash flow, just like they reduce earnings. However, capital expenditures are also treated as cash outflows in the period they occur when calculating free cash flow. There’s no spreading out over time through depreciation like with earnings. If you spend $500 on a new lemonade stand today, that’s a $500 cash outflow in today’s free cash flow calculation.

So, the key difference in how capital expenditures are treated between incremental earnings and incremental free cash flow is this: Incremental earnings are reduced by depreciation expense, which is a non-cash charge that spreads the cost of capital expenditures over time. Incremental free cash flow, on the other hand, is reduced by the full cash amount of capital expenditures in the period the cash is actually spent.

This distinction is important because earnings and free cash flow provide different perspectives on a company’s financial performance. Earnings are influenced by accounting rules like depreciation, which aim to match revenues and expenses over time. This can provide a smoothed view of profitability. Free cash flow, however, gives a clearer picture of the actual cash a business is generating and using. It’s a more direct measure of financial flexibility and the ability to fund dividends, debt repayments, or further investments.

For example, imagine your lemonade stand business is growing rapidly. You are making significant investments in new stands and equipment, which are capital expenditures. Your earnings might look good, showing consistent profits, because the depreciation expense is spread out. However, your free cash flow might be lower, or even negative in some periods, because you are spending a lot of cash upfront on these investments. This doesn’t necessarily mean your business is unhealthy; it might just mean you are in a growth phase requiring significant upfront investments. Understanding both incremental earnings and incremental free cash flow gives a more complete picture of your lemonade stand’s, or any business’s, financial health and performance.