Simply put: free cash flow

Two friends meet for lunch. One is an investment banker and the other is a software developer, who also happens to be a newbie investor. They start discussing the recent earnings season.

Yash: Have you checked Tata Steel’s Q4 results? I read that its consolidated net income was up 37% year-over-year and that it met estimates. This company consistently posts good numbers. Now I feel relieved to have invested my hard-earned money in a business that can provide me with good returns over time.

Nishit: Yes, the results were good. But in general, do you form an opinion of a company’s financial strength solely based on its net income?

Yash: Ya, why can’t we say that? Haven’t we heard that profit is the ultimate king?

Nishit: Have you heard of Free Cash Flow (FCF) by any chance?

Yash: No, I have never heard of FCF. What is that?

Nishit: Do you remember that you owed someone money or that someone owed you money?

Yash: Yes, I owe Pranav ₹2 lakh for a car I bought from him. Raj owes me ₹50,000 for the bike I sold him because I didn’t need it after I got the car back. We expect to settle the payments within the next month.

Nishit: Companies are also involved in this kind of thing, but in a somewhat systematic way. Net profit is the result of the difference between income and expenses of a business based on the concept of accrual accounting. That is, whether or not the money has been moved for the transaction, income and expenses are accounted for according to this period. Thus, a business will record revenue and this may add to the net profit, even though the money is likely to be received later from the customer. Same concept for expenses. What happens now if the customer does not pay the company? Although you have recorded revenue/profit from the sale, it is of no use.

Therefore, looking at net profit along with cash flow is a better way to analyze results. FCF is the real money any business earns in a year. It is the money that a business generates after receiving and spending cash from the day-to-day operations of the business and after paying the capital expenditures necessary to maintain or expand its business. FCF equals operating cash minus capital expenditures.

Yash: So this means that even if a company has a good net profit, it does not mean that it can spend anything or pay dividends if it does not have a strong cash position. To the right?

Nishit: Yes, you’re right.

Yash: But I can see that FCF and net profit are increasing and sharing the same pattern for Tata Steel

Nishit: Correct, both have shared a similar pattern over the years, but this may not be the same for all companies and you should check this when investing. Have you heard of an American company called Home Depot?

Yash: Yes, he is involved in the business of home improvement products

Nishit: To correct. The Home Depot faced a cash flow crisis during the 1980s. It had a stable net profit, but a growing FCF deficit, as the rate at which capital expenditures were made for business expansion was much higher than the rate of cash received.

Yash: So you mean that whenever there is a positive net profit and a negative FCF, the company is in trouble, right?

Nishit: Nope. That’s not what i meant. Let me give you an example of our favorite Netflix binge-watching platform. Netflix had the same situation in 2015-2019. It had no growing net profit but a negative FCF flow. They were using their FCF deficit to cater to the increasingly varied tastes of customers they were receiving. They were spending a lot of money on production and licensing costs to have a variety of content on its platform which was eventually harvested, and the company finally started having a positive and growing FCF since 2020.

Yash: So in my view, FCF is that money with which the company is free to do anything, like repaying creditors and paying dividends to shareholders. It is a powerful metric because it has the ability to reveal problems in any business before they are actually noticed at the bottom line. Also, keep in mind that a decreasing/negative FCF does not always mean bad for a business, as many times a negative FCF due to higher capex spending can benefit a business in the future. But you need to check how the FCF is doing, if the company’s debt is manageable while the FCF is negative, and if the capital expenditures will pay off in the long run.

Nishit: There! You just explained it perfectly. Thank you.

Published on

May 07, 2022

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