The net income of a company tell us if the business is profitable from an accounting perspective. However, its free cash flow tells us if the company is actually generating cash. Let us analyze how free cash flow, or FCF, is calculated and why it matters so much.
- What is Free Cash Flow?
- Comparison between net profit and free cash flow for Nestlé
- Price to Free Cash Flow ratio (P/FCF)
The objective of running a business should be to generate profits. We invest our capital, effort, and time today to generate good returns in the future. In the process, goods and services are offered to the marketplace, making society wealthier. This is the essence of capitalism.
But profits, even though necessary, are not everything. There is something else that is even more important to guarantee that a business will be able to continue running its operations: cash. If a business is profitable on paper but generates no cash, at some point it will not be able to pay its employees or suppliers.
What is Free Cash Flow?
Free cash flow tells us how much cash a business is generating for shareholders. It is the money available to the company’s shareholders after having run its operations and made investments for the future.
This is how free cash flow is calculated:
Let us analyze each of the components in the formula to see how they affect the calculation of free cash flow and why they matter. We will use Nestlé’s 2019 results as an example:
Net profit is the accounting item that tells us the difference between all revenues and expenses of a company. Revenue represents all sales made. On the other hand, expenses are all costs that have been incurred throughout the year, including taxes. The resulting net profit is used to assess how profitable a company is.
In the case of Nestlé, 2019 net income was CHF 12.61 billion Swiss francs.
Amortization and Depreciation
When a company makes an investment, for example, in a new factory, money is deployed upfront. Nevertheless, from an accounting perspective, the company considers that an investment and not an expense.
The money invested in the new factory is simply booked as an asset on the company’s balance sheet. Later on, as time goes by, the value of that asset goes down and that is booked as an expense.
For example, if Nestlé invests 100 million in a new factory and believes that it will be used for the next 20 years, it is assumed that the value of the factory will go down by 5 million every year. When calculating the company’s net profit, that 5 million will be considered an expense.
Depreciation refers to the loss of value of physical assets, while amortization refers to intangible assets. But it is the same concept.
The reason depreciation and amortization expenses are added to free cash flow is because those expenses only took place on the accounting side. From a cash perspective, the money was all spent upfront when the factory was built.
In the case of Nestlé, we would add CHF 3.71 billion from depreciation and amortization expenses to the free cash flow calculation.
Changes in Working Capital
Working capital is a metric used to analyze important things such as how much money our customers owe us, or how much money we owe our suppliers. As a company, we are interested in getting paid by our customers as soon as possible and paying our suppliers as late as possible.
But the important thing is to make sure our customers pay us. This is one of the main risks of only looking at a company’s net income. A company may be selling a lot simply because it is offering customers the option to pay later. That may be fine if customers end up paying their bills. But if payments stop, the company will be in big trouble, even though it had a positive net income.
For this reason, free cash flow will be impacted negatively if our customers owe us more money this year than they did last year. On the other hand, there will be a positive impact if we have managed to owe more money to our suppliers, as they would be financing our operations.
For Nestlé, the changes in working capital throughout 2019 had a positive impact of CHF 349 million.
This section captures all profits and losses that the company had from activities that are not part of its core business.
We would find things such as gains and losses on financial derivatives transactions, the possibility of paying taxes on a deferred basis, or dividends received from other investments.
In the case of Nestlé, these adjustments had a negative impact of CHF 821 million.
We have previously seen how we add depreciation and amortization expenses to free cash flow. The logic was that the money had already been spent in the past, so it was just an accounting expense.
However, by the same token, the company will need to make new investments for the future. Otherwise, productive capital will become obsolete. Imagine what would happen if Nestlé had not invested in any new factories or equipment since the 1980s!
For this reason, free cash flow will be reduced by the amount of money that the company has allocated to capital investments. For some sectors this can be a lot of money. Those are capital-intense sectors, such car manufacturers
It is true that a company can build and sell cars with very nice margins. But very much investment is indeed in new factories and technology to sustain that over time.
In the case of Nestlé, investments worth CHF 3.70 billion were made throughout 2019, which will obviously have a negative impact on free cash flow.
Comparison between Net Profit and Free Cash Flow for Nestlé
Let us now pay attention to Nestlé’s free cash flow in order to compare it with its net income:
For Nestlé, free cash flow is practically the same as net income. This is a very good indicator. It tells us that net income we see on the accounting side is also reflected in how much cash is being generated for shareholders. This is all money that the company could pay out in dividends.
If net income and free cash flow are similar, it is said that the quality of the company’s earnings is high, as they are reflected in cash being available to shareholders and are not mere accounting tricks.
If there are large discrepancies between net income and free cash flow, we will need to investigate why.
If free cash flow is significantly lower than net income, this can usually be explained by either of these two main reasons. Either the company has started selling products to customers who need financing, which can be dangerous and is a red flag, or aggressive growth is being pursued, which should be accounted for when valuing the company.
On the other side, if free cash flow is much higher than net income, the company may not be investing much in future production. This may be justified in sectors with no or negative growth. But is also something to pay attention to as the company may be jeopardizing its operations in the long term.
Price to Free Cash Flow Ratio (P/FCF)
As we have already seen in another post, the P/E ratio compares the share price of a company with its earnings per share. It tells us how many years of profits we are paying for a company.
Because profits and free cash flow are both important and may at times deviate from each other, it is also very useful to analyze the price to free cash flow ratio. This ratio compares the share price of a company with the free cash flow that the company generates per share. It is known as P/FCF and tells us how many years of free cash flow we are paying for a company.
Thus, if we have a P/FCF ratio of 15, the share price is 15 times the annual free cash flow that the company generates.
Just like with the P/E ratio, we will need to carry out additional analyses to determine whether that ratio is attractive or not. This will be assessed in the context of the company’s growth, its financial position, the sector in which it operates, the ratios its peers have, and the macroeconomic situation.
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