Education: Growth & Income Investing

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Paying Attention to Free Cash Flow

When it comes time for you and me to pay our monthly bills, it is always nice to have something left over once that last check has been written. Otherwise, we would never be able to purchase that new pair of shoes, go out for a nice dinner, save for a much-needed vacation…I think you get the picture.

The same logic can be directly applied to companies. When companies have finished paying the bills, what’s left over is commonly referred to as free cash flow. Growth and income investors should pay close attention to this very important measure. Let’s learn why.

Free Cash Flow Defined & Calculated

Free cash flow is defined as is the amount of cash that a company has remaining after it has paid all of its expenses. It is calculated as operating cash flow minus capital expenditures (investments in property, plant and equipment). Both figures can be found on a company’s cash flow statement.

Let’s go over the calculation for Kramerica Industries (fictitious company). As you can see from the table below, calculating free cash flow is very straightforward. But not so fast. It is important to keep in mind that the cash flow statement is cumulative—it contains results for the year thus far. I mention this because if you are calculating third-quarter free cash flow for Kramerica, you would subtract free cash flow of $2.75 billion from $4.80 billion, leaving the company with third-quarter free cash flow of $2.05 billion. For annual calculations, simply use the year-end figures (yeah, a little more simple).

Kramerica Industries: Third Quarter Cash Flow Statement

Cash Flows from Operating Activities: $5.75 billion

Capital Expenditures: $950 million

Free Cash Flow: $4.80 billion

Kramerica Industries: Second Quarter Cash Flow Statement

Cash Flows from Operating Activities: $3.50 billion

Capital Expenditures: $750 million

Free Cash Flow: $2.75 billion

The Ugly Stepchild

While the cash flow statement seems to be the least analyzed by Wall Street (they focus a majority of their attention on income statements and balance sheets), it is extremely important. This statement gives investors a clear cut view of a particular company's cash generating capabilities. If a company is lacking free cash flow, it will be very difficult, if not impossible, to pay down debt, participate in the acquisitions arena, make strategic investments, etc. Growth and income investors should also be concerned because this will put a company in a very difficult position to pay dividends to its shareholders. How can it without any cash at its disposal?

Earnings versus Free Cash Flow

Let’s consider a company that has posted impressive earnings on an annual basis while, at the same time, its free cash flow is not only negative but has declined every year for the past three years. Is this bad? Not necessarily.

Let’s revisit the calculation of free cash flow: operating cash flow minus capital expenditures. Capital expenditures include investments. If this particular company is just getting off its feet, it will need to invest quite a large amount of capital into various resources—namely property, plant and equipment. In this case, the aforementioned situation should be perfectly acceptable. Now if the company’s earnings were poor and declining, a red flag should immediately go up. This means that its spending is not benefiting the company’s bottom line—and it should.

Furthermore, if a mature company is generating poor free cash flows, this should be reason for concern. The best companies will still have a good amount of cash left in the tank even after dishing out large amounts of capital and posting impressive earnings.

Conclusion

While negative cash flows may not necessarily spell disaster, those looking for additional income in the form of a dividend will have to keep looking. When these companies dig into their pockets to locate excess cash to pay out to shareholders, their hands will come out empty. Also, if a company’ free cash flows are still positive but have been declining, a cut in its dividend may be in the near future. Be on the lookout for companies like this.