I came across an image on the internet this week.
It’s a good summary of a very important topic in finance/accounting that few understand. What I like most about this image is that it shows the link between the income statement, cash flow statement and how FCF is derived from the two.
Net income vs Free Cash Flow (FCF)
Net income can be defined as revenue less all expenses (including tax). Free cash flow is the cash generated by a business after adjusting for working capital requirements and maintenance capital expenditure.
One important concept to note is that the income statement and therefore net income is based on the accrual concept in accounting. In simple terms, the accrual concept means that revenue/expenses are recorded when they are earned/incurred, not necessarily when they are received/paid in cash.
This is simply a timing difference. All revenue is eventually received in cash and all expenses are eventually paid in cash.
But this is an important distinction because we need to know that the net income (reminder: revenue less expenses) of a business does not represent the cash earned by the business during that period.
And that is why we have the cash flow statement.
The purpose of the cash flow statement is to show how much cash a business received or paid during a period. We use the cash flow statement to calculate the free cash flow.
Later on, I’ll explain why the cash flow statement and free cash flow are much better ways to measure the health of a business.
What is Free Cash Flow
The name itself is self-explanatory but it’s worth breaking out the two components to solidify our understanding.
First, let’s have a look at the second part – Cash Flow. The important thing to remember here is that free cash flow is all about cash. Money in (or out). We need to make adjustments to get from our accrual-based accounting amount to a cash number.
The first part is that the cash flow must be “Free”. But what exactly do we mean by this? The best way to think about it is that free cash flow is the cash available to the business after meeting all cash requirements, including capital costs (e.g. equipment), to keep the business running.
Any cash available after meeting these requirements is “free”. Free in the sense that this is excess cash, cash over and above the amount the company needs to sustain its operations.
A company with “free” cash is in a great position because it can use this cash in many different ways. Some examples of this include:
- Expansion capex (growth)
- Hiring more employees (growth)
- Acquiring other companies (growth)
- Paying down debt (deleveraging)
- Paying dividends (capital disbribution)
- Stock purchases (capital distribution)
These are capital allocation decisions and are best saved for another post.
You’ll notice from the above list that free cash flow gives a business a lot of opportunities. That is why generating free cash flow, and not only profit is what makes a company financially successful.
How to Calculate Free Cash Flow
The starting point for the free cash flow calculation is net income. Take a look at the diagram above and you’ll see how net income, from the income statement, is the starting point of the cash flow statement (indirect method).
Remember that included in the net income figure is revenue and expenses for which the related cash flow did not necessarily take place during the period. Our starting point, net income, is based on accrual and we need to translate that to cash.
Cash flow from operations
To identify the actual cash flow generated from operations during the period, we need to make two adjustments to our net income figure:
- Add back non-cash expenses (e.g. depreciation)
- Changes in workings capital (e.g. accounts receivable, accounts payable, inventory)
By adjusting for the two items above we arrive at the operating cash flow for the period. In almost all instances, there will be a difference between net income and operating cash flow.
Note that I’ve only included to adjustments above. This is an oversimplification and there are many more adjustments we can make. However, the principal remains the same – we are converting an accrual number (net income) to a cash number (operating cash flows).
Maintenance Capital Expenditure
We have one final step before we can determine free cash flow and that is to take our operating cash flows, calculated above, and subtract maintenance capital expenditure.
Maintenance capital expenditure (capex) is the cash paid to acquire tangible assets to maintain the current level of operations. It is the minimum capex a company must incur each period to sustain its current output.
Any capex over and above this amount is called growth or expansion capex. The key distinction here is the maintenance capex is unavoidable, the business has to incur it to operate. Expansion capex is a capital allocation decision and is not required. That is why we do not subtract it from our free cash flow calculation. Growth or expansion capex is only available to companies that are generating free cash flow.
Free Cash Flow Summary
Let’s summarise the calculation above.
Our starting point was the net income of the business calculated using the accounting accrual concept.
We then adjusted this amount to reflect the actual cash flow for the period by adding back non-cash items and adjusting for changes in working capital. This gave us what is referred to as operating cash flow.
Finally, we subtracted the maintenance capital expenditure from our operating cash flow to determine the free cash flow of the business.
Free cash flow is available to be used by the business in a number of different ways outlined above. These are called capital allocation decisions because the company must decide how to best use the excess cash generated by the business.
Net Income vs Free Cash Flow
Taking what we have discussed above into account, a company should, at a minimum, generate sufficient cash to cover its operating costs, working capital requirements and maintenance capital expenditure.
Anything less than this would be considered negative free cash flow and is only sustainable for as long as investors (debt and equity) are willing to finance it.
Remember that investors fund on the basis that a company will generate free cash flow in the future. The share price of a company, being the equity value, is the present value of expected future cash flows. Therefore, a business that does not generate future free cash flow is worth zero.
At the opposite end of the spectrum, all the best businesses generate a lot of free cash flow. One of the reasons software businesses have such high valuations is because they generate an enormous amount of free cash flow.
The reason for this is the technology companies have good margins resulting in a high net income, low capital workings requirements (cash received upfront, delayed vendor payment, no inventory) and have low capex requirements.
Conclusion
The distinction between net income and free cash flow is something everyone in business should understand. Most people think solely in terms of net income or profit and incorrectly assume that a profitable company is a good company.
Profit is obviously important. A company will not exist if it continually makes losses.
But profit isn’t enough. At a minimum, a company has to convert that profit into sufficient cash (free cash flow) to maintain its operations.
Extra: Net Income and Free Cash Flow – The Early Days of Nike
If you’ve ever read the book Shoe Dog by Phil Knight you’ll know that in the early days the company was “profit rich but cash poor”.
The company used almost all the cash it received from selling shoes to pay expenses and purchase additional inventory to meet the growing demand. There were many times when the company almost ran out of cash.
If you only reviewed the income statement, you would have thought this company was doing well, and it was, but an income statement only reveals part of the story. A good investor or business operator needs to understand where the cash is being used. Nike used almost all the excess cash to buy more inventory.
As a company like Nike scales, this problem becomes less of an issue. It can start to access short-term funding from banks and negotiate longer payment terms with its suppliers. This improves the working capital cycle and frees up cash in the business. But it takes time and the business has to reach a certain level of maturity before it has access to these sources of finance.