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What is free cash flow and why is it so important?
Free cash flow is important to investors because it shows how much actual cash a company has at its disposal. This may sound like a simple point, but it is one which should rank extremely highly on an investor’s ‘need to know’ list.
When a company needs to service its debts, pay dividends or invest in equipment, it needs cash to do so. If a company has a large amount of excess cash, depending on the industry, it might be able to ramp up production, fuel acquisitions or return money to shareholders.
Free cash flow is the money left over after a company has met its operating and capital expenditure requirements and it can be the best way to differentiate between a good investment and a bad one.
HARD TO FUDGE
One of the best characteristics of free cash flow is that it is difficult to fudge using ‘creative’ accounting. This cannot be said for other important metrics such as earnings per share which can be manipulated.
Earnings per share (EPS) is simply the net income divided by the number of shares outstanding. One way that earnings can be manipulated is what management treats as a recurring cost and a one-off. Can a cost be a one-off if it happens every year?
Also, companies might start booking revenue before the cash has even been paid by its customers. Carillion was doing this and given that it was putting in low bids to win government contracts on paper thin margins, if customers delayed paying it could cause serious issues.
The shortfall in cash caused by the company not getting paid on time or in contractual disputes meant there was an increasing shortfall of the cash needed to meet its day-to-day obligations.
In hindsight, the demise of Carillion is not that surprising as without cash the company was forced to rely on its lenders who had grown concerned with the ballooning debt levels. They cut the lines of credit to the company which led to its demise.
CALCULATING FREE CASH FLOW
While there’s no ‘catch all’ way of determining a company’s amount of free cash, there are some widely accepted and easy to understand ways of working it out.
The easiest way is to simply subtract the firm’s capital and operating expenses from its operating cash flow. This latter information can be found in financial statements under Statement of Cash Flow under the section Cash from Operating Activities.
Once the free cash flow figure has been calculated, some fund managers like to use the free cash flow yield. This is the free cash flow divided by the market cap, expressed as a percentage.
This metric will show how much cash a company generates and compares it with the market value of the company. It is often used by private equity firms when sizing up an acquisition. These outfits, which typically borrow heavily to fund deals, may, for example, look at a business on a free cash flow yield of 7% and compare it
very favourably with borrowing costs of 3%.
For equity income investors it may be best to look at this metric before dividend yield as it could be seen as a better way of predicting a company’s ability to maintain its dividend or even increase its payout.
Free cash flow is also important for growth-oriented investors as those companies with bags of spare cash can reinvest the money back into the business.
CASH IS KING
Just as earnings and profit can be inflated by one-off items, these measures can also be hit by adjustments which have no impact on cash flow.
On 2 August first half results from aircraft engine maker
Rolls-Royce (RR.) revealed that on a statutory basis it had lost £1.3bn.
This included a £554m allocation for spending to fix problems on its Trent 1000 class of engines.
However, much of the remainder was accounted for by non-cash items including currency-related write downs and restructuring charges.
Negative sentiment towards the company in recent years has been linked to its disappointing cash flow performance.
A £211m improvement in the free cash flow performance year-on-year and reaffirmed pledge to deliver at least £450m for 2018 as a whole was therefore more relevant for investors and helped account for the positive response to the numbers, proving once again that cash is king. (DS)