Two friends meet for lunch. One is an investment banker and the other is a software developer, who is also a novice investor. They start arguing about the recent earnings season.
yash: Did you review Tata Steel’s fourth quarter results? I read that your consolidated net profit increased by 37% year-on-year and you have met the estimates. This firm has been posting good numbers consistently. Now, I am relieved to have invested my hard-earned money in a company that can give me good returns over time.
nishit: Yes, the results were good. But just asking in general, do you make an opinion about the financial strength of a company based solely on its net profit?
yash: Yes, why can’t we say that? Haven’t we heard that profit is king supreme?
nishit: Have you heard of Free Cash Flow (FCF) by any chance?
yash: No, I have never heard anything about FCF. What’s that?
nishit: Do you remember that you owed someone money or that someone owed you?
yash: Yes, I owe Pranav ₹2 lakh for a car I bought from him. Raj owes me Rs 50,000 for the bike I sold him because I didn’t need it after I bought the car. We plan to settle the payments over the next month.
nishit: Companies are also involved in this kind of thing, but in a somewhat unsystematic way. The net income is the result of the difference between the income and expenses of a company based on the concept of accrual accounting. That is, whether or not cash has been moved for the transaction, income and expenses are recorded as appropriate for that period. So a business will record the revenue and that can add up to the net profit, even if the customer is likely to receive the cash later. Same concept for expenses. Now, what happens if the client does not pay the company? Even if you have recorded the proceeds/profits from the sale, it is of no use.
Therefore, looking at net income along with cash flows is a better way to analyze results. FCF is the actual cash any business earns in a year. It is that cash that a business generates after receiving and spending cash from the day-to-day operations of the business and after paying the capital expenditures necessary to maintain or grow its business. FCF equals cash from operations minus capital expenditures.
yash: So it means that even if a company has a good net profit, it doesn’t mean that the company can spend anything or pay dividends if it doesn’t have a strong cash position. Right?
nishit: Yes, you are right.
yash: But I can see that both FCF and net profit are increasing and share the same pattern for Tata Steel
nishit: Correct, both have shared a similar pattern over the years, but this may not be the same for all companies and you should check this out as you invest. Have you heard of an American company called Home Depot?
yash: Yes, he is involved in the home improvement business.
nishit: Correct. Home Depot faced a cash crunch during the 1980s. It had a stable net income, but a growing FCF deficit, as the rate at which capital spending for business expansion was incurred was much higher than the rate cash receipt.
yash: So you mean that whenever there is a positive net profit and a negative FCF, the company is in trouble, right?
nishit: No. That’s not what I meant. Let me give you an example from our favorite binge-watching platform, Netflix. Netflix had this same situation during 2015-19. Had any increasing net gain but negative FCF stream. They were using their FCF deficit to satisfy the tastes of the more and more varied customers they were receiving. They were spending a lot of cash on production and licensing costs to have a variety of content on their platform which they finally reaped, with the company finally starting to have a positive and growing FCF from 2020.
yash: So the way I see it, FCF is that cash with which the company is free to do something like pay creditors and pay dividends to shareholders. It is a powerful metric because it has the ability to reveal problems in any company before they are noticed at the net income level. Also, keep in mind that declining/negative FCF does not always mean a bad thing for a company, as many times negative FCF due to spending more on CAPEX can result in benefits for a company in the future. But you need to check how the FCF is doing, whether the company’s debt is manageable while the FCF is negative, and whether the capital expenditure will pay off over the long term.
nishit: There you go! You just explained it perfectly. Thank you.
07 May 2022