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We explain why cash flow is so crucial and how investors can calculate free cash flow yield

In the latest instalment in our first-time investor series, we outline the importance cash flow plays when weighing a company’s financial health and future prospects.

‘Cash is king’ is the oft-quoted mantra of entrepreneurs and investors alike.

The reason is the cash a company generates cannot be fudged or flattered, unlike revenue, profits and earnings per share. Furthermore, a company’s capacity to generate positive cash flow and maximise long-term free cash flow (FCF) determines its ability to create shareholder value, and running out of cash is one of the most common reasons why businesses fail.

BACK TO BASICS – WHAT IS CASH FLOW?

Cash is the money in the bank that a company owns, whereas cash flow is the cash a company generates in a given period and is the operating profit adjusted for non-cash items such as depreciation and the investment made in working capital such as inventory, creditors and debtors.

Put simply, cash flow measures how much money is moving into and out of a business during a given accounting period. Analysis of cash flow provides management teams and investors with a snapshot of the amount of cash coming into a business, from where, and the amount flowing out.

Positive cash flow, defined as ending up with more liquid money on hand at the end of a given period compared to what was available when that period began, is the lifeblood of a company.

It enables a firm to pay its debts, settle any debts, reinvest in growing the business and return money to shareholders, while also providing a buffer against future financial challenges such as a downturn.

In contrast, negative cash flow indicates that a company’s liquid assets are actually decreasing.

Companies with a high operating cash flow, or with cash flow that is in an upwards trend, are generally considered to be in rude financial health, and typically more highly prized by investors.

A PROFITABLE COMPANY CAN RUN OUT OF CASH

Counterintuitive as it may seem, a company that is profitable can still run out cash, as cash and profit are different things. Whereas cash is the money a company has in its bank account and represents its liquidity, profits can include sales a company has made but hasn’t been paid for yet.

The key difference is that while profit shows the amount left over after all expenses have been paid, cash flow indicates the net flow of cash in and out of the business.

THE IMPORTANCE OF FREE CASH FLOW

Free cash flow is important to investors because it shows how much actual cash a company has at its disposal. When a company services its debts, pays dividends or invests in equipment, it needs cash to do so.

If it has a large amount of excess cash, depending on the industry, it might be able to ramp up production, spend on earnings-enhancing acquisitions or return money to shareholders.

Free cash flow is the amount of cash that a company has left over every year to pay its lenders and shareholders. It is essentially a group’s cash profits and is called free cash flow because the company is free to do anything it wants with it.

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 key metrics such as earnings per share (EPS) and profit, which can be inflated by the use of one-off items, or even revenue, which can be booked in the accounts before the cash has even been paid by a company’s customers.

Infamous construction and support services company Carillion, which went into liquidation in 2018, was performing such a trick, and putting in low bids to win government contracts on wafer thin margins, which meant if customers delayed paying it would be in big trouble.

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 its mushrooming debt levels. They cut the lines of credit to the company which led to its ignominious failure.

CALCULATING FREE CASH FLOW & FCF YIELD

Perhaps the easiest way to determine free cash flow is to subtract a company’s capital and operating expenses from its operating cash flow. This latter information can be found in financial statements under headings such as Consolidated Statement of Cash Flows under the section Cash flows from operating activities.

We’ve provided an example above in the form of statements from cash generative homewares retailer Dunelm (DNLM), which despite the pandemic, generated improved free cash flow of £174.7 million (2019: £152.8 million) in the financial year ended 27 June 2020.

Once the free cash flow figure has been calculated, some fund managers like to use the free cash flow yield.

Expressed as a percentage, free cash flow yield is calculated by dividing a companies free cash by its enterprise value (its market capitalisation plus any net debt or minus net cash).

It is often used by private equity firms, which typically employ borrowing to finance deals, when sizing up an acquisition, and is also a useful metric for equity income investors as it can indicate a company’s ability to maintain its dividend or even increase its pay-out.

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