Company economic performance
Higher or lower free cash flow?
In this post I will discuss the basic subtleties of free cash flow. The topic is what we can learn from a company’s financial statements, particularly the statement of cash flows, about its profitability and economic performance.
Free cash flow is: a) the money a company generates net of operating expenses and ordinary capital expenditures; less b) non-cash expenses; and adjusted for c) changes in working capital from the balance sheet.
Three cautions
First, three cautions. 1) There is almost no such thing in the world of investing as hard fact. The reported numbers in a company’s financial statements are usually based on various interpretations of reporting standards and some pretty important and often unspoken assumptions. Financial statements are notorious for being capable of being massaged.
2) Financial statements are not an end in themselves. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”
3) And related to 2) the object of the exercise is to understand a business. Warren Buffett says that his attitude when buying common stock is to “approach the transaction as if we were buying into a private business…. When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham. 1998) p.63
When we try to understand a cash flow statement, it is not simply a quantitative analysis. A business analysis is more a qualitative analysis than a quantitative analysis. It must be done with common sense and business sense. The numbers are tools to help direct and focus the mind. We must always remain skeptical of the numbers.
Higher vs lower free cash flow
Generally, the higher the free cash flow the better. But, many companies with lower free cash flow are better investments. That’s because the cash is deployed in growing the business.
Let’s look at changes in working capital as an example. This number represents the difference between current assets (like cash, accounts receivable and inventories) and current liabilities (like accounts payable and current debt). In a simple world, high working capital is thought of as a good thing. But often this is not true. A company that has too much inventory or is not taking advantage of low-expense debt opportunities will have a higher working capital than it should.
What about changes in working capital that impact the statement of cash flows. A company that is growing will often find that its operations consume a larger portion of its cash flow. This company’s growth might have produced larger inventory from year one to year two. Its accounts receivable might have grown on its increased business. On the other hand, a company that is shrinking will often end up with lower current assets as a result of lower inventories or lower accounts receivable which increase reported cash flow.
The numbers don’t tell the story by themselves. The reduction in supply inventories might be the result of greater efficiencies rather than a shrinking business. On the other hand, higher inventories might be a sign the company’s products are not selling rather than a sign the business is growing.
In the same way, increasing accounts receivable from one reporting period to another might be a good sign or a bad sign.
In short, the reading and understanding of a company statement of cash flow is not a simple straightforward thing.
Bottom line
The best company is one that generates substantial cash flow in excess of that needed to maintain the company’s assets and competitive position and that can invest that cash in profitable company growth.
Conclusion
The topic of cash flow and free cash flow can become quite complicated. I personally find the cash flow statement a much more useful document than the earnings statement. Learning to read them and understand them is well worth the effort.
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There is a lot more to learn about cash flow statements and free cash flow. The distinction between growth capex and maintenance capex is crucial. Things like capital leases and stock-based compensation complicate the subject further. Readers wishing to dig deeper might look at the following posts:
Heart of stock valuation: subtleties of free cash flow
Negative free cash flow can be desirable
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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