Statement of Cash Flow and Free Cash Flow

A Cash Flow Statement gives a good clue on company's financial health. But understanding Free Cash Flow (FCF) is even more penetrating. Read on..

Background

Every business organization, irrespective of the size, structure, and nature, needs cash for running the business smoothly. In the absence of sufficient cash, the business may not be able to fulfill long term and short term obligations, which might lead to discontinuation of business. 

So, if you are in the business of selling apples, you need some initial investment to first go and buy enough apples from a wholesaler or a dealer to be able to sell them. And then every day, you will sell some apples resulting in cash inflow, and buy some more from the wholesaler resulting in cash outflow. You will also have other cash outflows like paying maintenance and rent for the shop where you are selling those apples.

Types of Cash Flows

At a very high level, the movement of cash can be of two types i.e. cash flow and free cash flow. Cash flow refers to the inflow and outflow of cash to/from the organization.

Cash flow and Free cash flow are both important financial metrics used to determine the liquidity of a company. However, there are distinct differences between the two that allows investors to see how a company is generating cash and how it's spending it. Let us discuss them one by one.

Cash Flow

Cash flow is the flow of cash coming in and going out of a business over a certain period of time. Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders and pay expenses. Cash flow is reported on the Cash Flow (CF) Statement. Cash Flow Statement is one of the 3 main financial statements that you must go through before taking any investment decision.

[Recommended Read --> Understanding Balance Sheet Statement]

Cash Flow Statement

The Cash Flow Statement contains three sections detailing various kind of financial activities. 

1/ Operating Activities

In this section, the operating activities amount to the day to day business activities like sales or purchases of merchandise, payment to creditors, suppliers or employees, receipts from debtors, etc. 

This is the same as buying apples from a wholesaler and selling it to customers - representing the day to day operations.

2/ Investing Activities

You may, at some stage, get interested in expanding your apple business and may want to buy another adjacent shop selling apple juices. This will result in a cash outflow, since you will have to invest in that shop. But this is not an operational activity. This activity is listed as an Investing Activity and such activities typically account for the sale or purchase of an investment or an asset. 

3/ Financing Activities

Now, your business has done pretty well and you decide to give a Diwali bonus to all your staff in both the shops. This is a cash out flow but is neither an operational activity nor an investing activity. This is categorised as a Financing Activity. For a big company, this amount could be due to the issue or redemption of shares or debentures, payment of dividend, etc.

In a nutshell, the difference between cash at the beginning and the end of the financial year is regarded as cash flow for the respective year.

Is Cash Flow Statement not good enough?

It is important to note that Operational Activities in the Cash Flow Statement become the key activity because they are going to be repeated every day, every week, every month and every year of the company. They represent the core of the business that the company is into. Therefore, we need to get into something which is more vital than the cash flow itself. Here comes the need for Free Cash Flow.

Free Cash Flow

Free cash flow (FCF) is the cash a company produces through its operations (only Operational Activities and NOT Investing or Financing Activities) after subtracting any outlays of cash for investment in fixed assets like property, plant and equipment (typically termed as Capital expenditures or Capex). 

What are Capital Expenses?

Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets including property, industrial buildings, or equipment to keep the operations running at the desired level of efficiency. They are considered necessary to maintain a company's competitive position and operating efficiency. To continue with our earlier example, buying a new shop to venture into something new is not a Capital Expenditure, but buying a vehicle to efficiently transport apples from the wholesaler is a Capex, since it directly relates to your operational efficiency.

Thus, free cash flow or FCF is the cash left over after a company has paid its operating expenses and capital expenditures. 

What does Free Cash Flow signify?

FCF measures the cash flow available for distribution to all company securities holders. It can be envisioned as cash left after the financing of projects to maintain or expand the asset base. Free cash flow is used to measure whether a company has enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks. To calculate FCF, we would subtract capital expenditures from cash flow from operations.

In general terms, the higher a firm's free cash flow, the better the company is performing, making it a better investment, by some measures.

A positive free cash flow reveals that the company is generating enough cash to run the enterprise efficiently. However, the Negative free cash flow shows that the company is not able to generate sufficient cash, or it has invested money somewhere else which will generate high returns in the future.

FCF Trend

While a positive Free Cash Flow is a good sign, a more important sign for an investor is look at the trend of free cash flow over last many years. An increasing trend shows the strength of a company.

FCF Formula

The formula for free cash flow is:

FCF=Operating Cash Flow (CFO)- Capital Expenditures (CapEx)

where:

FCF=Free Cash Flow

This is a simplistic formula for calculating Free Cash Flow. The formula, for pros, gets slightly more complex.

Example of Free Cash Flow

Below is the cash flow statement for Exide Industries (screenshot taken from screener.in). Let us understand the health of the company from a cash flow / free cash flow perspective.

First rule to remember in any financial statement is that anything positive is an inflow for the company, and any negative denotes an outflow from the company.
Now, taking the above example, it is observed that:
1/ Operating Cash Flow for Exide for Mar 2019 is 1687 Crores (which is quite good, and their best ever)
2/ Capex is essentially fixed asset purchases, which is 811 Crores for Exide for Mar 2019.
3/ So, Free Cash Flow is 1687 - 811 = 876 Crores. This is the free cash that can be used to reduce debt, to pay dividends etc, and this is what interests the investors.

Takeaways

By analyzing both cash flow and free cash flow, we can see how much a company generates from their normal course of operations, what they're investing in and how much debt they're paying down or taking on. As a result, investors can make a more informed decision as to the financial viability of the company and its ability to pay dividends or repurchase shares in the upcoming quarters.

Free cash flow can be used to expand operations, bring on additional employees or invest in additional assets, and it can be put toward acquisitions or paid out in dividends to shareholders. 

On the other hand, the owner of a business with negative free cash flow should evaluate why FCF is negative. If the business has negative free cash flow because "extra" money is consistently reinvested for growth, then the negative number is a reflection of that growth strategy. When cash flow shortages are to blame, however, negative FCF could be a cause for concern.

Regards

Manoj Arora

Official Website