Free cash flow and cash conversion

In simple terms

Profit is an accounting measure; cash pays the bills. Free cash flow is the cash a business has left after running its operations and investing in the assets it needs.

Both numbers come from the cash flow statement. Capital expenditure appears in the investing section as purchases of property, plant and equipment and intangible assets.

Free cash flow is the money that can be used to pay dividends, buy back shares, repay debt or buy other businesses. That is why many investors see it as the truest measure of what a business earns for its owners.

A worked example

Maintenance and growth spending

Capital expenditure has two parts:

• Maintenance capital expenditure replaces worn-out machines, vehicles and buildings, and keeps the business at its current size.
• Growth capital expenditure adds new capacity, stores, products or markets.

Companies rarely report the split. A common rough estimate of maintenance spending is the depreciation charge, adjusted for inflation, because depreciation reflects the wearing out of existing assets. Some companies discuss the split in their MD&A or investor presentations.

The split matters because a company could, in principle, stop growth spending and turn more of its operating cash into free cash. Free cash flow before growth spending shows the cash-generating power of the existing business.

To the firm or to equity?

Two versions are used, depending on whose cash you are measuring.

• Free cash flow to the firm (FCFF) is cash available to all providers of capital, lenders and shareholders, before interest. It is usually calculated from operating profit after tax, plus depreciation, minus capital expenditure and minus the increase in working capital.
• Free cash flow to equity (FCFE) is what is left for shareholders after paying interest and adding any net new borrowing (or subtracting net repayments).

FCFF is used to value the whole business; FCFE to value the shares directly. The discounted cash flow lesson uses both. Under Indian accounting standards, interest paid may appear in operating or financing activities, so check where it is shown before calculating.

Cash conversion

Comparing free cash flow with net profit shows how much of reported profit becomes spare cash:

A business that regularly converts 80% to 100% of its profit into free cash needs little reinvestment, or earns high returns on what it does invest. One that converts 20% must reinvest most of its profit to keep growing, and its owners see less cash. The quality of earnings lesson uses the related measure of operating cash flow to profit.

When negative free cash flow is fine, and when it is not

Negative free cash flow is not automatically a problem.

• Fine: a company with good returns on capital is investing heavily to grow, and its existing business generates healthy cash.
• Concerning: free cash flow has been negative for many years, the company keeps borrowing or issuing shares to fund it, and the investment is not producing higher operating cash flow.
• A warning sign: operating cash flow itself is weak or negative while profit is positive, which points to working capital problems or weak earnings quality.

Why it matters

Free cash flow is what a business can actually return to its owners or use to strengthen itself. It is harder to flatter than profit, because it records cash when it moves. It is also the foundation of discounted cash flow valuation, and it underpins dividends, buybacks and debt repayment, covered in the next lessons.

Limitations

Free cash flow can be lumpy: a single large project can turn one year negative. It can be flattered in the short term by cutting necessary investment or by stretching payments to suppliers. Definitions vary, especially in how interest, leases and acquisitions are treated, so check how any quoted figure was calculated. Always look at several years.

Common mistakes

• Using profit as if it were cash.
• Judging free cash flow on a single year.
• Ignoring acquisitions, which are a form of capital spending even though they appear separately.
• Treating all negative free cash flow as bad, without asking what it funded.

Try it yourself

Choose a listed company and use five years of its cash flow statements.

1. Calculate free cash flow for each year as operating cash flow minus capital expenditure.
2. Add up five years of free cash flow and of net profit, and calculate conversion.
3. Compare capital expenditure with depreciation each year as a rough guide to growth spending.
4. Note what the company did with its free cash flow: dividends, buybacks, debt repayment or acquisitions.