Cash Flow is the movement (flow) of money that comes in and out of a business. Money that moves out (Spent) is known as Cash Outflows while money that moves in (Received) is known as Cash Inflows. Cash Flow is different to earnings as it is a real snapshot of when a business receives money and when it is likely to spend it. Cash flow is the true measure of a company’s financial position. The goal for every business long-term is to have more cash flow coming in than going out, ultimately leading to Free Cash Flow aka owner earnings.

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What is Cash Flow?

There are many different types of Cash Flow such as EBITDA, FCFF and FCFE. We will focus on two key metrics, OCF (Operational Cash Flow) and FCF (Free Cash Flow). It is not that the other measurements are not important, all metrics have a time and place, it is that nothing is more important to the long-term success of a business than Free Cash Flow.

Never take your eyes off the cash flow because it’s the lifeblood of business.

Richard Branson

Cash Flow represents all the net cash transferred into a business and all the cash that leaves it. If you’ve read the Cash Flow Statement Explained you would recall the three essential areas that make up the statement.

The first is operating activity which is all the cash inflows and outflows from the core business operation. Then there is investing activity which measures all the cash inflows and outflows from the investments made by the company. Then there is financing activity, which measures all the cash inflows and outflows the business uses to fund operations or reward shareholders.

Cash flow is very different to net profit and a better measure of value over earnings or EBITDA as they can be manipulated and are heavily influenced by certain line items. Cash Flow reflects how much money the company has left over (or not) to keep funding expansion, reinvesting, and ultimately rewarding shareholders.

Now, there is one caveat to all of this whilst Cash is King, it is not the end all that makes a successful company. There is a lot of focus in today’s world on Free Cash Flow or “Owner’s Earnings” that many investors forget that you can still have fantastic profitable investments that don’t generate Free Cash Flow.

Understanding Operational Cash Flow.

The first important Cash Flow metric is OCF (Operational Cash Flow). This refers to all the cash inflows and outflows related to the core business and operational activity. Understanding OCF is a great way to see if a company has enough cash to pay for its operations over the short term i.e. working capital.

Using the same small-cap business we used when breaking down the three financial statements, above is a snapshot of the operating activity segment. We can see that the business has generated $7.7m in operating cash flow. We can see what the company brought in very clearly, $42.3m, and what went out to keep the business running $32.9m (with some minor transactions to follow).

The formula is quite simple, how much cash was received from revenue (cash receipts) minus expenses paid out to keep the company running. The indirect and more common calculation is:

OCF = Net Income + Non-Cash Expenses – Increase in Working Capital.

Net Income is the last line on the Income Statement. We add back in non-cash items such as depreciation, amortisation, deferred income tax, stock-based compensation, and any write-downs on goodwill (intangible assets). The reason is that these non-cash expenses are an indirect cash inflow, meaning no cash has changed hands, however, they do impact the final cash position of the business.

There are a few ratios and metrics that incorporate OCF. The one I like to use the most is the OCF Margin. This measures operating cash flow against the total revenue the company brought in. The formula is Net Cash Flow from Operating Activity (OCF) divided by revenue. This shows how profitable a business is and how efficient they are at converting top-line sales into cold hard cash.

Working Capital.

Working Capital is the money left over and available to a company to meet current and short-term obligations. There are a couple of ways to calculate working capital. The most common is:

Working Capital = Current Assets – Current Liabilities.

Another way to look at working capital is to use an altered calculation that excludes cash and debt. It only considers the revenue that will be converted in addition to inventory on hand. It then deducts what is owed to suppliers and other short-term operating expenses.

This is a better way to look at “core activity”. I want to know exactly what money is coming in and out of the company without the impact of other inclusions in current assets and liabilities.

Working Capital = Accounts Receivables + Inventory – Accounts Payable.

The changes in working capital are important to understand. When inventory rises on the balance sheet it causes a cash outflow because it costs money to buy the goods. If accounts receivable increases, it indicates the portion of sales that have not been paid for. This reduces the cash as nothing has flowed into the business. If accounts payable and unearned revenue increase, this causes a cash increase. Why increase? Because the company owes the money and has yet to take the cash OUT to pay the bills.

Working Capital Assets	Working Capital Liabilities
Accounts Receivable	Accounts Payable
Inventory	Accrued Expenses
Prepaid Expenses	Deferred Revenue

➡️ Accounts Receivables: are the money customers owe the business. They have received the products and services but are yet to pay for them.

➡️ Accounts Payable: relates to all the money the company owes its suppliers and is yet to fall due. The company has received the goods.

➡️ Inventory: is the value of all the goods the company has already but is yet to be sold and therefore converted into revenue.

What does Operating Cash Flow tell us?

All this is great to know, but what does any of it mean? The short of it is it depends on the business, the business model and where the company is in its life cycle.

Positive Operating Cash Flow means a business generates more cash than it spends. This is a great sign and indicates the core operations are being efficiently run.

Negative Operating Cash Flow indicates that a company is spending more on operating than what it is bringing in. It could cause a strain on operations if a company does not have sufficient cash to fund its working capital needs. This is where “Financing Activity” comes in.

The less working capital a business needs the better. When you hear low capital intensity businesses this is what it means. The less cash a company requires to fund expansion and allocate to working capital the more money it has to spend on other activities.

The cash flow from operations is the most important of the cash flows. The reason is that if a company does not generate positive operating cash flow it has little cash flow to flow to the other two activities, Investing and Financing. It means a business will rely on financing activity by either raising capital by taking on debt or issuing more shares by an equity raise.

The operational cash flow section becomes the centre of attention for these reasons. Ultimately, as a business moves beyond the launch phase and crosses past the growth stage, it needs to be very efficient in its operational cash flow. If it does generate positive cash flow, it results in fuelling further investment and financing activity.

Now let’s look beyond Operating Cash Flow and into one of the most important metrics there is…

👑 Free Cash Flow is absolute king.

Free Cash Flow, also known as “Owner’s Earnings”, is one of the purest measurements of a successful business. In simple terms, if you owned a company privately, invested your capital into it, and have been growing it for years and the business stabilises, what would you want to be able to do with the company? To rip money out!

After a certain point in a business’s life, after all the reinvestments and years of hard work, you’d want to remove as much cash as you want for whatever you’d like to spend it on. Otherwise, why are you in business?

Although you can’t rip the cash out in a public company the same outcome is what you want. You want a company that takes your capital, invests it to grow, expand, and create more cash so that the owners can be rewarded. This is what FCF is. It is all the cash left over after a company has paid for operational activity and future investments and still has “spare” cash left over. FCF is all money that can be safely “ripped” out of a business and given back to owners without damaging the business operations.

OCF is the cash left over relating directly to core business activity. A business must invest to continue growing so it can’t be ripped out until after it has accounted for all the other cash outflows such as expanding the assets and other ongoing operations to support the business. What is left after all of this is pure Free Cash Flow available to shareholders.

The Free Cash Flow formula.

If you take all the cash a business generates and remove all the expenses to run the company and the investments into further expanding the business and investing in current assets or maintaining existing ones, you get free cash flow. The formula for working out Free Cash Flow is:

FCF = Operating Cash Flow – Capital Expenditures (CapEx)

Net Cash Flows are what the company needs for the future and cannot be pulled out. From this, we deduct CapEx (Capital Expenditures).

Free Cash Flow is a great measure of a company’s overall performance and profitability. Like the OCF Margin, the FCF margin determines how much Free Cash Flow can be generated from revenue. The higher it is the better the company is at converting top-line sales into pure cash. Investors can use Free Cash Flow to determine how well a company operates, and how much capital expenditures impact cash flow.

It also provides insights into the types of investments the company is making and whether they are providing an adequate return on investment.

What are Capital Expenditures (CapEx)?

Capital Expenditures are found under Investing Activity on the cash flow statement. CapEx measures how much a company has used to invest in new fixed assets, PP&E and the costs of maintaining existing assets. For example, all the funds a business uses for acquisitions, investments, upgrades, or the ongoing maintenance of existing property, equipment, technology, or infrastructure.

Companies need to either expand or protect (maintain) their asset base. This requires cash to do so. If a company produces a positive and growing net cash flow from operating activity, there is more to spend on investing activity.

CapEx can be broken down further into Maintenance CapEx and Growth CapEx.

Maintenance CapEx is the investments made into existing assets. This could be to upgrade or maintain what the business already has. For example, if a company owns a building and it needs work carried out to the roof. Maybe a piece of equipment needs to be serviced, upgrading certain parts. These are all maintenance expenses as it is a cost to maintain existing assets.

Growth CapEx are investments made into new assets that will help the company continue to expand. This could be a new acquisition of a business, a new factory or building, or a new technology stack the company needs. When a business is investing heavily into growth capital expenditures, it reduces the free cash flow.

Sometimes it may be beneficial to run free cash flow estimates using only maintenance CapEx. This may work well if the company has made a once off capital investment but not if the company is making large continuous investments that are likely to impact free cash flow into the future.

Investors need to understand the capital expenditures of the business to determine if they are bringing more value to the business.

What can Free Cash Flow be used for?

Once a company crosses into Free Cash Flow territory it has a few options to consider what to do with the leftover cash. The options will depend on a few factors that primarily revolve around further investment opportunities.

If a company runs out of investment opportunities and viable places to reinvest free cash flow it will (or should) return that capital to the equity owners. Sometimes management continues to invest in poor opportunities because cash is abundant. This leads to value destruction for shareholders. Investment opportunities should provide a reasonable return on capital otherwise why make them?

This is where companies make poor asset allocation decisions that have poor returns on them. Anything from over-acquiring, paying too much for an asset (too much goodwill) or expanding into other divisions that take precious resources away from core activity.

Management has a few options regarding what to do with Free Cash Flow, they are:

Share Repurchases: Where a company buys its own stock back, effectively increasing shareholder value if purchased at the right price.

Dividend Issuance: Where a company declares a dividend and rewards shareholders with a payout of the profits.

Debt Repayments: Management can reward shareholders indirectly by strengthening the balance sheet and paying back debt.

Reinvesting in the business: This could investment activity that further enhances organic growth and revenue.

Acquisitions: This is the purchase of other businesses that can be bolted on to increase top-line revenue or complimentary products and services.

Capital Allocation of free cash flow is not only the priority of management but also what investors need to observe. Prudent and diligent capital allocation will increase shareholder value, poor capital allocation will destroy it.

The difference between Levered and Unlevered cash flow.

There are a couple of variations to cash flow which are levered and unlevered. The key difference revolves around expenses. Levered cash flow measures the cash left over after it has met its financial obligations. Unlevered cash flow is the cash left before it has met its financial obligations.

Free Cash Flow to Firm (FCFF) is unlevered free cash flow. This is the sum of all the cash flows that relate to all the stakeholders of a business. This includes shareholders, bonds (debt) and other preferred stockholders.

Free Cash Flow to Equity (FCFE) is levered free cash flow. This is the sum of all the cash flow that is attributed to shareholders (equity owners) and assumes all debtors are paid in addition to working capital and CapEx requirements.

Unlevered cash flow does not factor in expenses such as debt repayments, interest expenses, taxes and operational expenses.

The terms relate to the company’s capital structure. If a business has no debt at all is known as an unlevered firm. If a company has some borrowings then it is a levered firm.

Free Cash Flow metrics to use.

Free Cash Flow can be used for several rations and valuation metrics. Below are the three key ones I use when looking at a company. As free cash flow is one of the best measurements to use when valuing a business, we can use it to determine, profitability, returns and operational efficiency with the below metrics.

Free Cash Flow Margin: (Free Cash Flow ÷ Revenue)

This reflects the amount of cash a company generates for every dollar of revenue. Obviously the more the better. If a company has a FCF margin of 10% this means that for every $100 in sales, $10 is pure cash left over. Companies with very healthy FCF margins continue to outperform and make for viable investments when purchased at the right price.

Free Cash Flow Yield: (Free Cash Flow Per Share ÷ Current Stock Price)

This ratio measures how much free cash flow per share is generated against the current stock price. If a yield is high, it may indicate an undervalued company. It can be treated like a dividend yield as this could be paid out to shareholders.

Free Cash Flow Conversion: (Free Cash Flow ÷ Net Earnings)

Earnings Quality can be determined by how much earnings flow through to Free Cash Flow. You want companies that can convert operating profits into cash. If there is a big discrepancy, then it’s not a great sign. A good rate may be around 100%. This means that a company is converting most of its earnings into free cash flow.

Is having NO Free Cash Flow bad?

A company that reports no free cash flow is not necessarily a bad business. Most companies in the launch or growth phase will sport negative free cash flow. Smaller companies and hyper-growth companies pump all available earnings and cash back into the business to keep growing.

To finance growth a business can’t pay anything out. It must continue funding expansion. Negative free cash flow can be a positive sign if the reinvestments are accelerating top-line revenue and moving towards increasing margins.

This will all be based on where the business is in its growth cycle. Investors need to determine where the company is investing and what value it is likely to bring to the business.

Long-term investments that pay off will often skew short-term earnings and results. The hope is the payoff will provide far greater free cash flow in the future. A lot of successful tech companies created tremendous shareholder wealth by pouring all available resources back into the business in the jeopardy of short-term results.

Yes, free cash flow is the end goal. A company can only grow for so long. Where a growth company starts to spit out free cash flow is when reinvestment opportunities start to slow, or when a company achieves operational leverage. This happens when more revenue starts to flow directly to the bottom line, which leads to more free cash flow.

So, don’t be turned off when you see no free cash flow. Understand why this is the case, where the company is sourcing its funding (Organic, Debt, Equity) and how long it is likely to keep operating like this. If a company does have negative free cash flow, I want to see revenue accelerating and then eventually the margins increasing as a company becomes more efficient.

In Summary…

When analysing companies, cash flow is where the opportunity is found when looking for long-term compounders. With the focus on FCF for many investors, this often means the valuation has these qualities built into the price.

I like to see FCF in companies that are still growing, have crossed into achieving operating leverage and still have a runway ahead before maturing. These companies may not be paying dividends or buying back shares. However, they will create a lot of shareholder value if management continues to allocate capital wisely. To value these businesses use a Discounted Cash Flow model.

Where I pay no attention to FCF is in smaller companies that are growing rapidly. I expect there to be no FCF for a while. Sometimes, I try to understand how long it will take before a company can generate free cash flow but that is not the key focus. I want companies to continually reinvest in growth opportunities that accelerate revenue. Revenue is the driver of growth. The revenue needs to convert to the bottom line, but initially, the top line is the key focus.

For these businesses, I still want to see healthy gross margins with very efficient operations. This means when a company scales back reinvestments and heavy operational expenses these margins can flow through to cash. If a company is a poor converter of top-line growth it usually will end up being a poor converter to free cash flow.

Another area I pay attention to is the capital intensity of the business model. If a company operates in a capital-intensive sector that requires a lot of maintenance CapEx as well as investments to keep growing, it means free cash flow will always be on the fence. So, I do prefer low capital-intensive industries with low working capital needs.