Show us your money - Free cash flow - By Darren Winters

Show us your money! —free cash flow

Everybody likes cash; we’re certainly no different when we are analysing stocks that we cover in the newsletter. More to the point we look at ‘free cash flow’, now don’t you go moving on to the next article! This may actually ensure you do not lose your shirt one day.

Any business owner will know the importance of good cash flow. In fact the reason for many of the country’s failed new businesses each year is not because the goods or services are not in demand, but because the cash flow was not managed well enough.

Now due to accountants being accountants, they have managed to invent a whole magnitude of types of cash flow, probably to try and bamboozle the layman and to ask for higher fees from their employers. There is plain old ‘ operating cash flow’, ‘operating free cash flow’, ‘discretionary cash flow’, ‘residual free cash flow’, discounted cash flow and good old ‘free cash flow’. Now if I have missed any out please do not write to me.

To confuse matters a little, not everyone can totally agree on what should be included and excluded in the calculations, so to keep things simple I have used the description that was taught to me on my MBA course.

But before we get onto boring equations, why do we like free cash flow so much? Well in short, this is what a company sets out to produce. It is the excess cash the company is generating from operations that can be used to benefit the shareholders through dividends, share repurchases, new investments, acquisitions, paying back debt etc. It is a real measure of the company’s financial strength.

A company can increase sales year on year, it can show great net income figures and brilliant earnings per share, but all of these can be manipulated quite easily. The earnings per share measure is probably the most manipulated of all yet this is often the headline figure that many judge a company by. Free cash flow is much less open to such manipulation. However there are two areas where a company might try and manipulate it. These are if they sell all of their stock and do not replace it within the same financial year, or if they stop spending money on capital investment. Both of these are can be checked within the accounts and normally can only be adjusted temporarily.

Okay, to the calculation this is reasonably simple, you just take the ‘operating cash flow’ (sometimes listed as the ’cash flow provided by operations’) and subtract

1. the taxes paid,


2. the cost of maintaining equipment (this is rarely seen as a figure in the company’s accounts so it is common practice to use the depreciation charge if the figure is not available)


3. The interest paid.

You will probably be thankful that many companies now actually quote this figure in their accounts, unless of course they do not have any!

If we look at the accounts for Rolls Royce (RR.L), they have actually shown their calculation of the free cash flow. They have been very transparent with their calculations as well. That said they have shown the cost of rationalisation as a deduction from the operating cash flow, it could be argued that it should sit above the line.

I have shown their first half figures just as an example of what we would be looking for in a turnaround business. Here we can see that their free cash flow has been increasing year on year. As previously explained this means that they have more money to pay their investors or to use for the betterment of the business going forward.



Whilst I have not completed the exercise for Marks and Spencer, having taken a quick look at the balance sheet it would suggest that their free cash flow has been reducing on a year on year basis just by looking at the operating cash flow.

There have been a number of studies carried out that show that a company that has a strong free cash flow will outperform the market. This is not too surprising as they are most likely to be in good financial shape.

Some analysts are now looking at free cash flow as a ratio to the number of shares, thus occasionally you will see the term free cash flow per share. This must not be mixed up with cash flow per share; the word ‘free’ is essential. The calculation is simply the amount of cash flow divided by the number of shares outstanding.

When looking at free cash flow (FCF) it is recommended that you look at more than one period as in the example above. It is also wise to compare each year with the earnings per share (EPS) over the same period. This way you may notice any anomalies if the EPS is continuing to rise yet the
FCF is up and down. There may be good reason for this but you would then investigate further.

So in summary it may take a few minutes to calculate free cash flow, but it should not be ignored if you’re serious about buying a stock and holding it for any period.

Regards
Darren Winters