The cash flowing in and out of a company is a great indicator of its health. Companies need liquidity to be able to pay their bills and keep their bankers at bay.
But there's a confusing panoply of metrics: cash from operations, free cash flow, cash profits. If cash flow is the life blood of a business, how do you measure a company's blood pressure?
Cash flow statement
The starting point is the cash flow statement. International Accounting Standards require a business to split its cash flows into three categories: those associated with its operations, investing activities and financing activities.
Most commonly, you'll see this in a company's accounts looking something like this (which I've simplified by stripping out and combining lines):
The three categories of operations, investing and financing are clearly separated, and at the bottom there is a reconciliation of the cash flows to opening and closing cash balances.
Alice in Wonderland
The first thing to note is the Alice in Wonderland-like distinction between 'cash generated from operations' and 'net cash generated from operating activities'. "When I use a word, it means just what I choose it to mean," as Humpty Dumpty said in the book.
Cash generated from operations is operating profit with depreciation added back, adjusted for changes in working capital. It is usually reconciled to profit in a note, making it one of the most important notes to look at in a company's accounts. It looks something like this:
Cash generated from operations indicates how much cash a company is making from its basic activities. Depreciation is added back because it's just an accounting entry. Profits with depreciation added back are sometimes called cash profits. Start-up companies that have invested heavily may make cash profits while they are still loss-making, because of high levels of depreciation.
Increases in inventory or receivables are also deducted in calculating cash generated from operations, because these absorb cash. A growing company might be increasing sales, but spending all its cash building up stock.
Most companies regard interest and tax as integral to their operations, so put them in the first segment of the cash flow. That produces net cash generated from operating activities. It's a mouthful, but a useful subtotal. Not all do: Rolls Royce (LSE: RR), for example, puts interest into the financing category. It also puts the reconciliation of cash to profit on the face of the cashflow statement, so at first sight it looks a very different statement.
Cash conversion refers to how efficiently a company is turning profits into cash. I prefer to measure it by comparing net cash generated from operating activities with operating profit. Remember operating profit has depreciation taken off, so the cash flow figure may be greater. If the ratio is much different from one, it's reason to look more closely.
The next section of the cash flow statement is more straightforward. Typically, companies invest cash in capital expenditure and acquiring new businesses. If the figures are large, you need to look at how they have been financed: from operations, or from new financing?
Some capital expenditure is necessary just to maintain a company's current activities, rather than to expand. That's usually called maintenance capex. It's an important concept as, long term, a company should generate enough cash from its operations to cover maintenance capex, otherwise it's running its plant into the ground.
The accounting standard encourages, but doesn't require, a company to disclose how much of its capex is maintenance capex. Usually, you can get a decent idea from the narrative in the accounts.
It's a useful number to estimate, and allows you to calculate a figure for an important concept: free cash flow. For our purposes, that's generally defined as net cash flow from operating activities less maintenance capex.
Free cash flow measures the cash that a firm is producing for its shareholders. For that reason it's often used a valuation metric, by calculating price to free cash flow (i.e. market cap divided by free cash flow). But beware, there is a multitude of variants for calculating free cash flow(including those used in discounted cash flow analysis which deduct tax-shielded interest charges).
The final, financing, segment of the cash flow statement would be clear cut, but for the inclusion of dividends. For most listed companies, dividends are not a discretionary expenditure, at least not without the share price collapsing. So it often makes sense to treat dividends as a fixed charge, like interest and tax.
Probably the easiest way to capture this is to compare net cash generated from operating activities to the dividend, a form of cash dividend cover. If the dividend is not covered, then it is being financed by property sales, lenders, or the shareholders themselves.
To recap, three useful measures are:
Cash conversion: net cash generated from operating activities ÷operating profit.
Price: free cash flow, where free cash flow = net cash generated from operating activities – maintenance capex.
Cash dividend cover = net cash generated from operating activities ÷ dividends paid.
BY Tony Reading
Published in Investing on 24 April 2012