Cash Flow
The Cash Flow Statement is, for many analysts, the most important financial statement of a company. Unlike the Profit and Loss statement (P&L), which shows accounting profit, the Cash Flow statement reveals the actual cash the company has generated and, even more importantly, what it has done with it.
It makes it possible to see where the money really goes: whether it is used for business operations, investments or returning capital to shareholders.
The Cash Flow statement is built from Net Income in the Profit and Loss statement (P&L). However, it is essential to understand that Net Income is an accounting figure, not the cash the company actually receives in its account. It is the result the company must report under accounting standards. So, to get a truer picture of cash generated, we start from “Net cash provided by operating activities”.
Once we have analyzed the Cash Flow statement, we can see where the cash goes:
- Investments.
- Acquisitions (M&A).
- Share buybacks.
- Cash position after all investments.
- Cash position at the start and end of the period.
In some cases, part of the cash may be classified as restricted—for example, due to litigation or other obligations that require a certain amount of money to be held in reserve.
Below we look in more detail at CAPEX and FCF (Free Cash Flow), two fundamental concepts that are essential to understand.
CAPEX
This refers to the investment a company makes in its non-current assets, which may be tangible (land, machinery) or intangible (patents, software).
There are two types of CAPEX:
- Maintenance CAPEX: Investment needed to keep assets in their current operating condition.
- Growth CAPEX: Investment to expand the business’s capacity and productivity.
It is crucial not to confuse CAPEX with OPEX (Operating Expenditure). Main differences between them:
| CAPEX | OPEX | |
|---|---|---|
| Accounting treatment | Non-current asset (investment). Depreciated/amortized over its useful life. | Operating expense |
| Cost | Usually high. | Usually low. |
| Examples | Purchase of land, machinery, store refurbishment, purchase of licenses. | Salaries, advertising, restocking supplies. |
To arrive at real FCF, it is very important to use maintenance CAPEX, since growth CAPEX is a one-off, non-recurring investment. However, companies rarely report maintenance and growth CAPEX separately. To normalize it, two methods can be used:
- Use the sector’s average CAPEX/Sales ratio.
- Use Depreciation and Amortization (D&A) as a proxy for maintenance CAPEX. Although not 100% accurate, it is a very useful approximation.
The normalization rule is simple: if CAPEX is greater than D&A, use D&A; otherwise, use CAPEX.
Free Cash Flow
Free Cash Flow (FCF) is the amount of cash a company generates after covering all its basic obligations to keep the business operating.
FCF is a non-GAAP metric, meaning it is not governed by generally accepted accounting standards; moreover, it is not valid for analyzing financial companies.
We should therefore use our own formula and make sure it is always the same for consistency.
Formula:
Why FCF and not Net Income?
Net Income is an accounting metric that can include non-cash expenses (expenses that are not real outflows) and therefore may not correctly reflect the company’s actual cash position.