Intellectual Thoughts by Sanjay Panda !!!!!: Free cash flow: Is it free after all?????

Tuesday, July 24, 2007

Free cash flow: Is it free after all?????

The best things in life are said to be free and the same holds true for cash flow! Investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to repay debt, pay dividends, buy back stock and facilitate the growth of business all important undertakings from an investor's point of view.

How and what of FCF
The formula for calculating Free Cash Flow (FCF) is as:

Net Profit + Depreciation - Capital expenditure - Changes in working capital - Dividend

FCF takes into account not only the earnings of the company but also the past (depreciation) and present capital expenditures, capital inflows and investment in working capital. Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distribution (from subsidiaries) or debt elimination can reward investors in the future. Better free cash flows are therefore a reason for the investment community to cherish. On the other hand, an insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business

From a companys point of view
A better FCF definitely indicates better efficiency on the part of the company. But what is pertinent for investors to note is that simply assessing the FCF on the basis of its absolute value is not prudent. It is imperative to also assess as to what components have contributed to the same.

Let us take a hypothetical example of two companies, A and B, both of which have garnered the same FCF for the current financial year.

Estimated free cash flow
(Rs) Company A Company B
Net profit 75 120
Add: depreciation / amortisation 20 5
Less: Capital expenditure 5 15
Add/ (Less): Decrease /(Increase)
in wkg capital
10 (10)
Less: Dividend 20 20
Free cash flow 80 80

Prima facie although appearing similar, if you delve a little deeper there is a stark difference in their performances. While company A, despite having lower earnings has benefited by adding back depreciation and decrease in working capital, company B has invested in capex and working capital. This indicates that while company B is investing for future growth, company A is not sufficiently geared up for the impending challenges. This also means that investors in company B can expect rewards in future while those in company A should sit up and take notice of what is ailing it.

From a sectors point of view
As explained earlier, cash flows are dependant on the capital expenditure and working capital liabilities borne by the company. This however, differs as per the dynamics of the sector in which the company is operating and should be seen in that light. While sectors like banking require minimum expenditure on capex (as a % of their turnover) those in pharma, engineering, FMCG or commodity sectors require to invest a substantial amount in R&D and capacity expansions.
To conclude...
FCF is not only a mirror image of the present but also a sneak preview into the future. The implications of the components of cash flow may not be explained in the annual reports, but is left to the investors prudence to diligently scrutinize the same and try to read between the lines. The legendry investor Benjamin Graham once said, The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.

Free cash flow, is not free after all!

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