Free cash flow and the fight for better financial statements
Free cash flow and the fight for better financial statements
Lessons on investing and business performance from George C. Christy's seminal book.
So I read George C. Christy’s book Free Cash Flow for the second time. It’s an excellent book, but it is a little pricey, which may put off readers from buying it. That’s a shame because it is a truly great instruction manual for building more transparent financial statements.
Christy highlights the limits of accrual accounting and its role in distorting the net income (or “profit”) figure in traditional financial statements. Booked revenues and costs may not match the actual cash flowing into and out of a company’s back accounts—which actually determine its health and performance. Christy presents a new kind of financial statement that uses cash flow, not accrual accounting, as the basis for a far more transparent picture of a company’s performance.
Fortunately, Christy shows how to build this transparent new statement with a few simple steps.
Yes, dear reader, I am continuing down the business rabbit hole. I thank you for your everlasting patience… 😅
Free cash flow tells you more than net income
Let’s start with the terminology.
A business with free cash flow has cash leftover from its income, after it has paid all of its commitments.
Free Cash Flow = Net Cash from Operations - Capital Expenditures
Growing free cash flow is good. The business is getting better at generating excess cash from its operations.
Shrinking or negative free cash flow is bad. The business is getting worse at generating excess cash and becoming unprofitable.
It is generally understood that positive free cash flow is a sign of investing and business success. Free cash flow is your real return on your investment in the company.
The first reason is that as a whole or part-owner of a business, the free cash flow it generates is yours to use. You can pay yourself a dividend with that money, you can buy back more of the company’s outstanding shares, or you can make acquisitions.
The other reason is that cash is like oxygen to a business. Not the theoretical kind, but the kind that actually sits in a safe or in a bank account.
Net income, unlike free cash flow, is an accountant’s construct. It includes myriad non-cash elements and can be manipulated by unscrupulous managers. But, for historical reasons that we’ll get into shortly, net income is used as the primary measure of a business’s profitability.
Net Income = Booked Revenue - Booked Costs - Booked Depreciation - Interest and Taxes
When you apply for a mortgage, the bank does not ask you for your net income. It does not accept non-cash income or expenses. It wants to see your salary. It wants to see the hard cash in your bank account.
Nor does your bank accept net income deposits. It accepts hard cash deposits. It does not clear a cheque until it has received the cash from the recipient.
Why should businesses or investors, argues Christy, be any less demanding?
Free cash flow measures real business and investor return, not net income. More specifically, the cash flowing out to an investor minus the cash paid for their investment is the only true measure of investor return.
So, how do we find companies that succeed in generating free cash flow, and avoid those that don’t?
The challenge is in recognising the use and abuse of accrual accounting.
Look out for abuse of accrual accounting
Income statements and balance sheets use accrual accounting, a core part of generally accepted accounting practices—named GAAP for shorthand. The law requires that businesses report their quarterly and annual performance with accrual accounting.
But what is accrual accounting?
Let’s say you and your best friend decide to start a small business selling lemonade. You agree that your friend will squeeze the lemons, and you’ll make the signs and handle the money.
One sunny day, you sell a lot of lemonade to a neighbourhood party, and the host says, “I don’t have the money right now, but I’ll pay you in a week.” You and your friend agree because it was a lot of lemonade, and you’re excited about the money you’ll get.
Even though you won’t see the cash until next week, you count that sale today because you already did the work—you squeezed the lemons, made the lemonade, and delivered it to the party.
Instead of waiting until you get the cash to say, “We made a sale,” you record the sale right away. This is what businesses do when they use accrual accounting. They record income when they earn it (like when they sell lemonade) and expenses when they incur them (like when they buy lemons), not necessarily when cash changes hands.
See the problem? You booked the revenue even though you didn’t receive the cash yet.
What if the host fails to pay you?
For a lemonade operation the stakes are small. But if publicly listed companies are able to do this, and they abuse this, they can mislead investors into thinking they make more money than they actually do.
This is how “profitable” companies can go bust. They book lots of revenue that never hits their bank account, right up until they have to pay hard cash for salaries and capital expenditures.
Free cash flow is not immune to manipulation. But it goes a long way to avoiding companies that abuse accrual accounting.
EBITDA is not a cash flow metric
Christy torches the idea that EBITDA (earnings before interest, taxes, depreciation, and amortisation) measures cash flow in any meaningful way.
People get into the habit of using EBITDA without ever thinking why they use it.
The depreciation and amortisation are indeed non-cash parts of the income statement. When management pays out for an asset, rather than have a single expense on one year’s balance sheet, they can choose to expense it using depreciation, smoothing a big number into smaller numbers divided up over the life of the asset.
EBITDA pretends to be a cash flow metric by doing the first part—adding back non-cash expenses—but then failing to the second part—subtracting real cash expenses, like capital expenditures or working capital requirements. In other words, it adds back the depreciation and amortisation expenses to earnings, but fails to subtract the cash the company actually pays for ongoing maintenance and growth.
Relying on EBITDA is like pretending that it does not matter whether a business spends $10m or $100m in capital expenditures to increase earnings by $20m.
Don’t use a bad proxy for cash flow, exhorts Christy. EBITDA is a bad solution to the accrual problem, and it is unfortunately a popular one.
Think this is too much? Christy hasn’t even gotten started yet.
Return on equity is a meaningless concept
Return on equity is often used as a proxy for business success.
But what does it actually measure?
Net income divided by shareholder’s equity, you might say. While theoretically correct, it doesn’t answer the question.
Christy says it well.
Investors are interested in the expected cash flows generated by the fixed assets of a going concern, not in the book value of fixed assets.
Christy is saying that it is dangerous to rely on book values, like shareholder’s equity, without understanding how they’re calculated.
Book values are an accountant’s estimates. They are what a business’s assets might sell for.
Book values are, in other words, irrelevant to the investor concerned with cash flow. They tell you almost nothing about the net cash flows associated with those assets.
But surely shareholder’s equity can’t be a useless figure? That tracks the net assets owned by shareholders, right?
Christy disagrees.
The Retained Earnings account, often the account with the largest balance in Shareholders’ Equity, is essentially an aggregate of the current year’s Net Income (or Loss) and all prior years’ Net Income (or Loss) numbers. So Return on Equity has nothing to do with return, at least not for investors and companies.
I have already conveyed Christy’s exhortation that investor return is not a function of net income, book values, or accounting estimates.
You should be less concerned about the book values of assets and a lot more concerned with capital expenditures, which tracks what the company actually pays in cash to maintain its assets and capital.
Capital expenditures represent the reinvestment of a company’s cash. If a company spends X on capital expenditures and earns free cash flow of 2X, then that is the real business success that return on equity tries and fails to represent.
Investor return is a function of the net difference between cash invested and cash received from the investment.
Not return on equity.
A better free cash flow statement is possible
Christy’s goal in the book is to lay out a “Free Cash Flow Statement” that provides a simplified and accurate picture of a business’s performance.
Publicly listed companies are already required to report a cash flow statement. But Christy’s statement is different. It is much simpler and he aims to give investors and managers a much clearer figure of cash business performance.
You start with the revenue figure from the GAAP income statement, and use the reported cash flow statement for the rest of the figures.
So before you begin, you’ll need: (1) the GAAP income statement’s reported total revenue; (2) the Net CFO (cash flow from operating activities) from the reported cash flow statement; (3) change in working capital, usually inside the Net CFO section, and finally (4) the capital expenditures, usually found at the bottom of the reported cash flow statement.
This new statement takes a little bit of arithmetic to construct. The only part not already reported, that you have to calculate yourself, is “Cash operating costs”—I recommend leaving this as one of the last steps, because you will need to have worked out your amended “Operating cash flow” figure to calculate it.
Here are the elements in Christy’s new and improved statement:
Revenue — The free cash flow investor still uses the revenues reported on the GAAP income statement. But they use them with a cold, dispassionate eye.
Cash operating costs — Equal to revenue minus the operating cash flow figure, which in turn is calculated below. Calculate that first, then come back to this line. Think of these costs as the actual cash paid for the business’s day-to-day operations. The lower this is, the better.
Operating cash flow — Take the Net CFO figure from the reported cash flow statement and subtract the change in working capital from the same statement.
Operating cash flow margin — This is our operating cash flow figure divided by our revenue figure. This tells us how much of our booked revenue actually reaches the bank account as cash. The higher this margin, and the more this margin increases, the better our business is at generating cash inflows.
± Change in working capital — This is the figure we used earlier, after grabbing it out of the Net CFO section of the reported cash flow statement. It is either a positive or negative number, tracking cash inflows and outflows from the company’s working capital account.
Capital expenditures — This is on the reported cash flow statement. It records the cash spent on maintenance and growth. I like to think of capital expenditures as the actual cash spent by a business to maintain and grow its balance sheet.
Free cash flow — This is equal to the figure already on the cash flow statement, so you can just transplant that figure as-is, but it is also equal to operating cash flow plus the change in working capital, minus capital expenditures.
Here is an example, Widget Corp:
Revenue: $500m
- Cash operating costs: $478m
= Operating cash flow: $22m
± Change in working capital: -$5m
- Capital expenditures: $2m
= Free cash flow: $15mIsn’t this just the same as the reported cash flow statement?
No.
Normally a part of Net CFO on the reported cash flow statement, we separate out the change in working capital, because this can often distort free cash flow. We subtract it from Net CFO to get the “true” operating cash flow—the actual cash earned from operations.
If the change in working capital is a very large figure, it can artificially inflate free cash flow, because it is still a part of the calculation.
In that situation, if changes in working capital are large each year as a percentage of free cash flow, we have to wonder why so much cash is tied up in working capital? This could mean unused inventory stacking up in a warehouse or growing amounts of unpaid receivables and payables.
That doesn’t sound like the slick, efficient, cash-gushing operation we want to see.
Christy’s new statement fixes this problem by making it plain and obvious.
Here’s another example, Manipulator Corp:
Revenue: $500m
- Cash operating costs: $478m
= Operating cash flow: $22m
± Change in working capital: +$250m
- Capital expenditures: $2m
= Free cash flow: $270mSee what happened there? The increased free cash flow catches our eye. But on closer inspection we realise that the company only generated eight per cent of that free cash flow through its operations.
The company clearly has more cash than before, but this is still bad. The high free cash flow is not related to ongoing operations, and is therefore unsustainable.
Where does this leave us?
Christy tells us what we ought to look for in his new financial statement for a given company:
Consistently high or increasing operating cash flow margins — This tells us that a company is getting better at converting its booked revenues into cold hard cash. Low or decreasing margins indicate a dying business model.
Small and controlled changes in working capital — Be very wary about large and sudden changes in working capital, especially if they are positive. They are short-run ways for management to boost free cash flow.
High free cash flow with respect to capital expenditures — Ideally a company has to pay very little in capital expenditures to generate free cash flow. It is very hard for managers to deploy capital with a positive return.
High and growing free cash flow derived from operating activities — This part should be obvious. The best company, through its own day-to-day operations, positively gushes cash. It is likely to continue doing so year after year.
This is only a summary of my takeaways from the book. I recommend you buy Free Cash Flow right now.
Rather than expense the $10m in capital expenditures paid in a single year, a company can spread it into $1m expenses over ten years’ worth of income statements.
Remember how to subtract negative numbers. If your Net CFO is $100m and your change in working capital is -$10m, then this is equal to $100m - (-$10m) = $100m + $10m = $110m. If your change in working capital is +$5m, then the calculation is $100m - $5m = $95m.