When assessing the profitability of a company, it is important to concentrate not on its reported earnings but on the cash flows that it generates

Understanding Finance

When assessing the profitability of a company, it is important to concentrate not on its reported earnings but on the cash flows that it generates. Earnings can be easily manipulated through accounting wizardry, but cold, hard cash is much harder to falsify.

Despite most of the industry agreeing with Warren Buffett that ‘cash is king,’ everyone seems to have their own preferred measurement of cash flow profitability. I will run through a few of the more common definitions of cash flow favourites.

The first, and most commonly used for valuations, is simply called ‘free cash flow (FCF).’ The formula is as follows:

FCF = cash flow from operating activities (CFO) – net capital expenditures (net capex)

CFO is essentially the cash profit the company generates by carrying out its day-to-day operations. Net capex is what the company needs to spend each year in order to keep operating. This spend includes the likes of upgrading or purchasing buildings or machinery. This is a net number as it takes account of any profit made on selling a warehouse, for example. 

The idea of free cash flow is to give investors a feel for how much cash is left over to grow the business, and generate shareholder value, after all expenses, debt, and charges have been paid.

The second term is free cash flow to the firm (FCFF). This is similar to the first but for one difference; the treatment of the interest expense (the amount paid to debt holders). FCFF is the cash available to all investors, both equity and debt holders. Because the debt holders are the recipients of the interest paid out by the firm (net of tax), when considering cash available to all investors you need to add this amount back. Therefore:

FCFF = FCF + interest expense net of tax

These are just two examples of many common cash flow metrics. Next time you read about a company’s cash profitability, make sure you find out which classification is being used. 

Understanding Finance

Helping clients understand what we do is key to building relationships. To explain some of the industry jargon that creeps into our world, we’ve pulled together a section of our site to help.

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