Free Cash Flow: Free, But Not Always Easy
by Ben McClure, Contributor
The best things in life are free, and the same holds true for cash flow. Smart investors
love companies that produce plenty of free cash flow (FCF). It signals a company's
ability to pay debt, pay dividends, buy back stock and facilitate the growth of business -
all important undertakings from an investor's perspective. However, while free cash
flow is a great gauge of corporate health, it does have its limits and is not immune to
accounting trickery.
What Is Free Cash Flow?
By establishing how much cash a company has after paying its bills for ongoing
activities and growth, FCF is a measure that aims to cut through the arbitrariness and
"guesstimations" involved in reported earnings. Regardless of whether a cash outlay is
counted as an expense in the calculation of income or turned into an asset on the balance
sheet, free cash flow tracks the money.
To calculate FCF, make a beeline for the company's cash flow statement and balance
sheet. There you will find the item cash flow from operations (also referred to as
"operating cash"). From this number subtract estimated capital expenditure required for
current operations:
Cash Flow From Operations (Operating Cash)
- Capital Expenditure
---------------------------
= Free Cash Flow
To do it another way, grab the income statement and balance sheet. Start with net
income and add back charges for depreciation and amortization. Make an additional
adjustment for changes in working capital, which is done by subtracting current
liabilities from current assets. Then subtract capital expenditure, or spending on plants
and equipment:
Net income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow
It might seem odd to add back depreciation/amortization since it accounts for capital
spending. The reasoning behind the adjustment, however, is that free cash flow is meant
to measure money being spent right now, not transactions that happened in the past.
This makes FCF a useful instrument for identifying growing companies with high up-
front costs, which may eat into earnings now but have the potential to pay off later.
What Does Free Cash Flow Indicate?
Growing free cash flows are frequently a prelude to increased earnings. Companies that
experience surging FCF - due to revenue growth, efficiency improvements, cost
reductions, share buy backs, dividend distributions or debt elimination - can reward
investors tomorrow. That is why many in the investment community cherish FCF as a
measure of value. When a firm's share price is low and free cash flow is on the rise, the
odds are good that earnings and share value will soon be on the up.
By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash
flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings
growth can force a company to boost its debt levels. Even worse, a company without
enough FCF may not have the liquidity to stay in business.
Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate,
FCF is not infallible. Crafty companies still have leeway when it comes to accounting
sleight of hand.
Without a regulatory standard for determining FCF, investors often disagree on exactly
which items should and should not be treated as capital expenditures. Investors must
therefore keep an eye on companies with high levels of FCF to see if these companies
are under-reporting capital expenditure and R&D. Companies can also temporarily
boost FCF by stretching out their payments, tightening payment collection policies and
depleting inventories. These activities diminish current liabilities and changes to
working capital. But the impacts are likely to be temporary.
The Trick of Hiding Receivables
Let's look at yet another example of FCF tomfoolery, which involves specious
calculations of the current accounts receivable. When a company reports revenue, it
records an account receivable, which represents cash that is yet to be received. The
revenues then increase net income and cash from operations, but that increase is
typically offset by an increase in current accounts receivable, which are then subtracted
from cash from operations. When companies record their revenues as such, the net
impact on cash from operations and free cash flow should be zero since no cash has
been received.
What happens when a company decides to record the revenue, even though the cash will
not be received within a year? This question is inspired by telecom equipment maker
Nortel Networks' year 2000 financial statements. The receivable for a delayed cash
settlement is therefore "non-current" and can get buried in another category like "other
investments". Revenue then is still recorded and cash from operations increases, but no
current account receivable is recorded to offset revenues. Thus, cash from operations
and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to
catch.
Conclusion
Alas, finding an all-purpose tool for testing company fundamentals still proves elusive.
Like all performance metrics, FCF has its limits. On the other hand, provided that
investors keep their guard up, free cash flow is a very good place to start hunting.
by Ben McClure, (Contact Author | Biography)
Ben is director of McClure & Co., an independent research and consulting firm that
specializes in investment analysis and intelligence. Before founding McClure & Co.,
Ben was a highly-rated European equities analyst at City of London-based Old Mutual
Securities.
