I have started a series of posts on understanding financial statements. This is because I have received questions from readers asking whether there is a need to have a financial background in order to analyse annual reports/financial reports.
I did not receive any formal finance or accountancy training. The only course I took was a Accountancy 101 module during my university days. The only advantage I have over those with zero knowledge is understanding terms like “account receivables” and “cost of goods sold”. This can be learnt using Google. So that means that you do not have to be an accountant to do the same research that I’m doing. To start off, I will be introducing the term “Free Cash Flow”.
Alan Miltz has this saying that “Revenue is Vanity, Profit is Sanity and Cash Flow is King”. I agree with him that the importance of cash flow can never be understated in a business.
In this post, I will look at the concept known as free cash flow and why it is important, what it means and how to use it when analyzing companies. Also, at a more basic level, how to derive free cash flow from the company’s financial statements.
What is “Free Cash Flow” and Why is it Important?
If you try to look up “Free Cash Flow”, or FCF, on the internet, you will get multiple different definitions. This is because people define it differently, and companies also define it differently depending on the industry.
BUT… The basic idea of FCF is very simple; It is a company’s yearly discretionary cash flow.
In other words, after a company pays off its expenses, working capital items like Inventory and its capital expenditures, how much cash is left?.
|+ Cash flow from operations||Statement of Cash Flows|
|– Capital expenditure (CAPEX)||Balance Sheet (Difference betw current period and previous period of Property, Plant and Equipment)|
|= Free Cash Flow|
This is important because it speaks to the core problem that you have when analyzing a business which is what should the company be spending its money on if the company generates a lot of extra cash? Should the company;
- Expand its business and hire more employees (increase operating expense)
- Spend more on its working capital such as inventory to prepare more to stock to sell later on?
- Spend more on capex to boost its long term growth?
- Invest in other business to diversify its earnings?
- Repay outstanding debt to reduce its interest expense ?
- Issue dividends or repurchase shares to return money to its shareholders?
The point is, if the company is generating alot of extra cash, this is what we should think about to see if the company is making the correct decisions to deploy their cash in order to grow the company. There is no simple answer and these are just possibilities for the company to consider.
Negative Free Cash Flow?
On the other hand, what if FCF is negative or a very small number? Well, the first thing we have to look out for is to see if it is a recurring issue or a one-time event.
This is because if the company is facing negative FCF consistently, it could mean that the company is spending too much somewhere or it might not be using their working capital efficiently enough. The worst case is that the business model is broken. Once you have figured out the above, you will be able to assess how the company could fix the problem (eg. by raising debt or restructuring).
Leaving Out the Other Items
In the FCF formula, we only use “cash flow from operating activities” and not “cash flow from financing or investing activities”. This is because what’s in these sections is optional and it’s not truly required for the core business to run.
Yes there are times where we need some financing to soothe our cash flow shorfall, but none of the activities is truly “required” for the business to operate. Similar to expenses, the only things that we are really required to pay for the business to run is our “Cost of Goods Sold”, operating expenses, working capital items and CAPEX.
So in my view, the best definition for FCF is “cash flow from operations” minus the capital expenditures.
Using and Interpreting Free Cash Flow
There are a few ways investors use FCF to analyse companies
- Discounted Cash Flow (DCF) Analysis – In this type of analysis, you value a company based on the net present value of its cash flows in the future. The FCF definition that I used earlier if different and you will require to modify the components of FCF as appropriate and use that to evaluate what a company might be worth now.
- Leveraged Buyout Analysis – The usage of FCF here is different as in this case, what you do is you use it to figure out how much debt the company can reap each year. In other words, you use the FCF a company generates consistently to find out how much debt it can repay and that tells you how much you could pay for the company upfront in cash and how much debt you can raise to buy the company.
- Standalone Analysis – This is what I usually do. Analysing a company’s financial statements to find out its FCF generating capabilities. You would want to know if a company’s FCF is growing or declining yearly, the rate of growth/decline and the drivers of the growth/decline.
More on Standalone Analysis
Just to explore this a little bit more, from your analysis of the company’s FCF generating capabilities, there are 3 scenarios you will have;
Best Case = The company’s FCF is growing because of increase in sales and revenue, capturing more market share and is able to improve its margins (eg. economies of scale – as company grows, expenses do not necessarily scale up linearly with revenue).
Good Case = Company’s FCF is growing because of cost cutting measures which lead to improve in margins and less capex required each year.
Warning = Company is facing falling sales and profits. However, in this case, FCF could still be either positive or negative. ( Could be due to creative accounting, decrease in working capital, increase in non-cash charges such as depreciation, slashing capex or increase income from divestment or non-core activities.
I will be doing a FCF comparison of 2 SGX listed companies, Valuetronics (SGX:BN2) and Venture Corp (SGX:V03).
|Free Cash Flow Calculation||31-Mar-16||31-Mar-17||31-Mar-18||31-Mar-19||31-Mar-20|
|Cash Flow from Operations||289.27||160.54||63.53||404.07||327.82|
|Less: Capital Expenditure||-26.89||-43.79||-82.39||-47.06||-118.76|
|Free Cash Flow||262.38||116.75||-18.86||357.01||209.06|
|Annual Net Income||120.44||154.07||204.73||199.48||178.94|
|Changes in Working Capital||121.03||-41.55||-199.93||145.18||93.15|
|Revenue Growth Rate||NA||16.49%||25.44%||-0.87%||-16.77%|
|Net Income Growth Rate||NA||27.92%||32.88%||-2.56%||-10.30%|
|Cash Flow From Ops Growth Rate||NA||-44.50%||-60.43%||536.03%||-18.87%|
|Free Cash Flow Growth Rate||NA||-55.50%||-116.15%||1992.95%||-41.44%|
|Capex as % of Cash Flow from Ops||9.30%||27.28%||129.69%||11.65%||36.23%|
|Capex as % of Rev||1.38%||1.92%||2.89%||1.66%||5.04%|
For Valuetronics, Cash flow from operations is mostly growing except for 2018 when it declined. Capex for that FY also increased and that led to a negative FCF. Capex seems inconsistent and in my opinion, it will be better if management can help to differentiate maintenance capex and expansion capex.
To understand the reason why, we refer to the FY2018 Annual report and it explained that Cash flow from ops decreased due to the increase in working capital, which reflects the movement in trade receivables, inventory and trade payables, in line with the revenue growth that year. We can also see that in 2017 and 2018, they experienced strong earnings growth but had negative changes in working capital leading to lower FCF.
To sum up, FCF is inconsistent and is more impacted by the working capital and capex rather than revenue and profit. Valuetronics could do better with improving their working capital and inventory management such as granting shorted credit terms to their customers to enable better collection of trade receivables.
An interesting point to note is that Valuetronics is increasing their cash hoard by about 60% since 2018. Investors should look out for management’s plan with the FCF generated. It is possible that the company might use it to increase their dividends or repurchase more stock in the future.
|Venture Corp (SGX:V03)|
|Free Cash Flow Calculation||31-Dec-15||31-Dec-16||31-Dec-17||31-Dec-18||31-Dec-19|
|Cash Flow from Operations||233.88||231.31||448.53||254.22||229.7|
|Less: Capital Expenditure||-14.99||-33.51||-36.97||-58.85||-35.19|
|Free Cash Flow:||218.89||197.8||411.56||195.37||194.51|
|Annual Net Income||153.99||180.68||372.82||370.06||363.13|
|Changes in Working Capital||2.41||-42.52||-37.53||-204.66||-218.83|
|Revenue Growth Rate||NA||8.20%||39.33%||-12.98%||4.27%|
|Net Income Growth Rate||NA||17.33%||106.34%||-0.74%||-1.87%|
|Cash Flow From Ops Growth Rate||NA||-1.10%||93.91%||-43.32%||-9.65%|
|Free Cash Flow Growth Rate||NA||-9.63%||108.07%||-52.53%||-0.44%|
|Capex as % of Cash Flow from Ops||6.41%||14.49%||8.24%||23.15%||15.32%|
|Capex as % of Rev||0.56%||1.17%||0.92%||1.69%||0.97%|
Venture Corp has consistent cash flow from operations and free cash flow except for 2017 where they had an stellar FY performance with revenue and net income improving by 39.33% and 106.35% respectively.
Revenue and net income growth is on an increasing trend and it is contributing to FCF growth to a certain extent. However, high working capital has sort of restricted the potential FCF that Venture can have. From their annual report, it shows that they are facing with an increase in trade receivables and decrease in trade payables which reduces the cash flow of the company.
The main takeaway is that with Venture’s capex staying consistent and low as a % to Revenue, good working capital management will easily result in an increase in FCF.
We have defined Free Cash Flow as Cash Flow from Operations minus Capital Expenditures and explained why it’s important.
We have also gone through the possibilities of positive or negative FCF and what is tells you about a company. If the company generates a lot of Free Cash Flow, it has many options to utilize the cash. If FCF is negative, we need to understand if it’s a one-time issue or recurring problem, and then figure out why.
We also looked at how to use and interpret FCF when analyzing companies. It’s used in a DCF (or at least, a variation of it) to value a company. It’s also used in a leveraged buyout (LBO) model to determine how much debt a company can repay. Finally you can calculate FCF on a standalone basis for use when comparing different companies.
We have also seen 2 examples of companies that are generating FCF.
FCF applies to most companies. Sometimes it is less stable for certain firms, such as growth companies, but I myself prefer to evaluate companies by their cash flow generation capabilities.