Follow the cash and the cost of staying competitive

Profit is an accounting measurement. Cash is what pays suppliers, staff, lenders and shareholders. A good financial review needs both.

Operating cash flow

Operating cash flow measures the cash produced or used by normal operations after working-capital movements. It is not identical to net profit.

A business expanding rapidly may have to purchase materials and extend credit to customers. That can absorb cash even while sales and accounting profit grow. This is not automatically bad, but it deserves explanation.

Figure 1Why growth can absorb cash before it returns it

1. 1Buy materialscash goes out first
2. 2Hold inventorycash sits in stock
3. 3Sell on creditprofit is recorded; cash is not
4. 4Collect receivablescash finally returns

Capital expenditure

Capital expenditure, often shortened to capex, is money invested in longer-lived assets such as machinery, buildings and production equipment. Some projects maintain existing operations; others increase future capacity.

A manufacturing company cannot simply stop maintaining plant and still expect safe, reliable production. The important distinction is between spending required to protect existing earning power and investment intended to create additional earning power.

Free cash flow: a useful starting measure

A common simplified calculation is:

Free cash flow ≈ Operating cash flow − Capital expenditure

Consider two fictional businesses:

Both generate the same operating cash flow, but the amount remaining after capital expenditure differs. This alone does not prove that Stable Services is better; Machinery Works might be building profitable new capacity.

Figure 2Same operating cash, very different free cash

	Stable Services	Machinery Works
Operating cash flow	$2.0m	$2.0m
Capital expenditure	$0.3m	$1.5m
Simplified free cash flow	$1.7m	$0.5m

Ask what the spending achieves

Review several years rather than one. Look for repeated spending that merely replaces worn-out assets. Evaluate whether larger investments subsequently lead to increased sales, margins, production capacity or returns.

If you are reading a manufacturing annual report, ask the operational questions too: Is a new plant necessary? How old is the equipment? Are breakdowns rising? Is the business spending to reduce unit costs or simply to avoid falling behind?

Cash conversion over several years

A useful habit is to compare operating cash flow with net profit year by year. The ratio is sometimes called cash conversion. Over a run of years, a healthy business usually converts most of its profit into operating cash, and often more than all of it, because depreciation is an expense that uses no cash in the year it is recorded.

Single years vary for ordinary reasons: a large order shipped just before the year end, a build-up of stock before a busy season, or a tax payment that fell into one year rather than the next. The pattern over five years matters more. If operating cash flow is consistently well below profit, ask where the difference is going. Usually the answer is in working capital, such as receivables or inventory growing faster than sales, and the notes and balance sheet will show it.

Turning working capital into days

Working capital is easier to compare across years when it is expressed in days. Using the fictional company from Chapter 3, with revenue of $10 million and cost of goods sold of $6.5 million, suppose year-end receivables are $1.5 million, inventory $1.2 million and payables $0.8 million.

• Receivable days = receivables ÷ revenue × 365 = 1.5 ÷ 10 × 365 ≈ 55 days
• Inventory days = inventory ÷ cost of goods sold × 365 = 1.2 ÷ 6.5 × 365 ≈ 67 days
• Payable days = payables ÷ cost of goods sold × 365 = 0.8 ÷ 6.5 × 365 ≈ 45 days

Figure 3The working-capital cycle in days

Receivable days55 days

Inventory days67 days

Payable days, subtracted45 days

Cash cycle77 days

The cash conversion cycle, receivable days plus inventory days less payable days, is about 77 days here: roughly how long the business waits between paying for its materials and collecting cash from its customers. The figure itself matters less than its direction. A cycle lengthening year after year means more cash tied up for each dollar of sales; a shortening cycle releases cash. Year-end balances can be unusual, so compare the same date each year and treat the result as a guide rather than a precise measure.

Estimating maintenance spending

Annual reports rarely split capital expenditure into the part needed to maintain existing operations and the part that expands them. A rough starting point is to compare capital expenditure with depreciation over several years. Depreciation approximates the rate at which existing assets are being used up, so spending persistently far below depreciation may mean assets are being run down, while spending far above it suggests expansion, or rising replacement costs.

Treat this as a clue, not a calculation. Depreciation is based on the historical cost of assets, which may be well below what it costs to replace them today, especially after a period of inflation. Management commentary sometimes describes major projects and their purpose; read it, then check in later years whether the promised capacity, cost savings or sales actually appeared.

Include leases and acquisitions

Two items can make free cash flow look better than the business deserves if they are left out.

The first is lease payments. Under the lease accounting described in Chapter 2, the principal part of lease payments appears in financing cash flow, outside the usual free cash flow calculation. For a retailer or any business that leases most of its premises, the rent is a real cost of operating. Subtracting the principal lease payments gives a fairer measure.

The second is acquisitions. Buying another business appears in investing cash flow, separately from capital expenditure. A company that grows by regularly buying smaller competitors may show strong free cash flow on the simple measure while spending heavily to achieve its growth. Look at the acquisitions line over several years and ask whether the businesses bought have earned a reasonable return on the price paid.

See where the free cash flow goes

Free cash flow can be used in a limited number of ways: paid out as dividends, used to buy back shares, used to repay debt, spent on acquisitions, or kept as cash. The financing section of the cash flow statement, together with the investing section, shows which choices management made.

Over several years, this record says a great deal about how the company is run. A company that pays dividends larger than its free cash flow, funding the difference with new borrowing, is not sustaining its payout from the business. A company that buys back shares when its share price is high and issues new shares when it is low is moving value away from its continuing shareholders. Chapter 6 returns to buybacks; here, the aim is simply to see whether the uses of cash match what the business actually generates.

Interest and tax belong in the picture

Operating cash flow in Australian accounts often includes interest and tax paid, but presentation varies: some companies classify interest paid as a financing flow. Before comparing free cash flow between companies, check where each puts interest and tax, so that one company is not flattered by a presentation choice. For a business with significant debt, interest is a real call on cash that comes before any return to shareholders.

Capital intensity

Some businesses need far more capital than others to produce each dollar of sales. A simple measure of this is capital expenditure as a share of revenue, taken over several years. Suppose, for illustration, that Stable Services has revenue of $8 million and Machinery Works revenue of $12 million. Their capital expenditure of $0.3 million and $1.5 million is then about 4% and 12.5% of revenue respectively.

A capital-intensive business is not a poor investment by definition. It may face less competition because few rivals can afford the investment, and its assets may last for decades. But it has less room for error. In a downturn, it must keep maintaining expensive equipment while sales fall, and in an upturn it may need to spend heavily before it can grow. For such businesses, the questions in “Ask what the spending achieves” above deserve particular care, and the return on that capital, discussed in Chapter 6, is the measure that ultimately matters.

Read the investing section as a whole

The investing section of the cash flow statement includes more than capital expenditure. It shows purchases and sales of businesses, investments and property, and sometimes loans made to other parties. Reading the whole section helps avoid misleading conclusions.

A company may show low net investing outflows in a year because it sold a building or a division, not because it spent little on its operations. That sale is not repeatable, and the free cash flow it appears to create will not recur. Conversely, a year of unusually heavy investment may reflect a single large project that will not be repeated soon. Separate the recurring items from the one-off ones before calculating an average free cash flow.

Free cash flow per share

For shareholders, the total free cash flow matters less than their share of it. Dividing free cash flow by the number of shares on issue gives free cash flow per share, which can be tracked over time just like earnings per share.

This matters most when the number of shares changes. A company that grows its free cash flow by 10% while issuing 10% more shares has not increased the cash attributable to each share at all. One that grows free cash flow more slowly but steadily reduces its share count may be delivering more to each owner. Chapter 6 returns to this when discussing buybacks.

Cash flow warning signs

A few patterns in the cash flow statement deserve a closer look whenever they appear:

Figure 4Cash flow patterns worth investigating

• Ask: Operating cash flow below profit for several years running
• Ask: Receivables or inventory growing much faster than sales
• Ask: Capital expenditure persistently below depreciation
• Ask: Dividends funded by new borrowing rather than free cash flow
• Ask: Large, recurring "one-off" acquisitions
• Ask: Payables stretched to make operating cash look stronger

The last item is easy to overlook. A company can improve its operating cash flow in a single year by delaying payments to its suppliers. Payable days rising sharply at a year end can flatter the cash figure, and the improvement reverses when the bills are paid. Comparing payable days across several years shows whether the change is lasting or a timing effect.

A worked example: growth that absorbs cash

Rapid growth is the most common reason a healthy business shows weak operating cash flow. Suppose a fictional distributor grows revenue from $10 million to $13 million in a year, a 30% increase, while keeping receivable days and inventory days unchanged at about 55 and 67 days and its gross margin at 35%.

Receivables rise in proportion to sales, from about $1.5 million to about $1.95 million, an increase of roughly $450,000. Cost of goods sold rises from $6.5 million to $8.45 million, so inventory at 67 days rises from about $1.2 million to about $1.56 million, an increase of roughly $360,000. If payables also grow in proportion, from $0.8 million to about $1.04 million, they supply about $240,000. The net extra working capital needed is about $570,000.

If the distributor’s profit for the year is $1.2 million, about half of it is absorbed by the growth in working capital before any capital expenditure. Nothing has gone wrong; the business is simply funding its larger size. But it shows why fast-growing companies often need to borrow or raise capital even when they are profitable, and why a slowdown in growth can release cash surprisingly quickly.

The test of whether growth is healthy is whether the working-capital days stay steady. If receivable or inventory days rise as the company grows, the cash absorbed is larger than growth alone explains, and the reason deserves investigation.

Check the cash behind the dividend

Dividends are often judged by the payout ratio: dividends as a share of net profit. A ratio of 60% means the company pays out 60 cents of every dollar of profit. That is a useful figure, but dividends are paid in cash, not profit, so it is worth also comparing them with free cash flow.

Using the earlier example, Machinery Works generates simplified free cash flow of $0.5 million. If it pays $0.9 million in dividends, it is paying out more cash than its operations leave after investment, and the difference must come from existing cash, borrowing or asset sales. That can continue for a year or two, for example during a period of unusually heavy investment, but it cannot continue indefinitely. Stable Services, with $1.7 million of free cash flow, could pay the same dividend comfortably and still retain cash.

A dividend that is well covered by free cash flow over several years is far more likely to be sustained than one that depends on the company’s lenders or on selling assets.

Key takeaway

A business is more financially flexible when it consistently generates cash after the investment needed to sustain its operations.

Quick reference

• Compare net profit with operating cash flow.
• Identify large movements in receivables, inventory and payables.
• Examine recurring capital expenditure separately from major expansion projects.
• Treat simplified free cash flow as a starting measure, not a complete valuation.