Value plus Growth – Part 2:  Free Cash Flow

Value and growth investors who want to beat the market need to have a good understanding of a company’s fundamentals before they can make a stock picking decision. Fortunately, there are a number of methods that are commonly used to examine the financial statements of a company. Basically there are three types of financial statements, the Balance Sheet, the Income Statement and the Cash Flow Statement.

Financial Statements

The Balance Sheet presents the book value of all assets, liabilities and equity of the company at a point in time, such as the end of the fiscal year. The term balance means that all the assets must equal the sum of the liabilities and equity. As such, it provides a snapshot of the company’s financial condition on the given date.

The Income Statement or Profit and Loss statement measures the money received for the sale of products and/or services is transformed into net income. The purpose of the income statement is to show if the company made or lost money during the reporting period. The problem with income statements is that items that some accounts depend on the accounting treatment they receive such as FIFO (First In First Out) or LIFO (Last In First Out) to measure inventory. In addition some accounts depend on the judgment and estimates of management and as a result are subject to being manipulated.

The Cash Flow Statement shows the company’s incoming and outgoing money during a set time period, usually a quarter or year. It shows how changes in cash are affected by changes in the income statement and balance sheet. The cash flow statement measures the cash that moves into and out of a company’s bank accounts. As a result it is a useful analytical tool to determine the performance of a company. The rest of this article will focus on the Cash Flow Statement and some simple ways to use it to assess a company’s value. For investors seeking more information on how to analyze financial statements, then I suggest reading Financial Statement Analysis and Security Valuation by Stephan Penman.  By focusing on the output of financial statements, Dr. Penman helps readers understand how to use financial statements to value companies.  While expensive, this text book is an excellent reference for any investor who likes to do their own analysis and will pay for itself very quickly.

Cash Flow Statement

As mentioned above the cash flow statement measures the cash that flows into and out of a firm’s bank accounts. For investors, cash is king. It is hard to hid financial misdeeds or problems in bank balances. These bank balances show the truth in the financial performance of a company.

Cash Flow Statements are comprised of three components: Cash used and generated in operating the business. Cash used and generated from investing activities. Cash used and generated from financing activities.

Cash from operations includes the business activities of producing and delivering a product and/or service as well as collecting the money owed to the company for that product or service. This section of the Cash flow Statement measures the actual cash received for delivery of the product or service and the cash spent to create and deliver the product or service. To arrive at the operating cash flow number, you take the Net Income from the Income Statement and add back changes in non cash related accounts such as depreciation, deferred tax, amortization as well as increase/decrease in asset and liability accounts such as receivables, inventories, and payables. In the example below we see the comparison of Accenture Ltd (ACN) and EMC Corp (EMC) for the latest reporting quarter. Notice how the total Cash Flow from Operating Activities for both companies exceeds net income for the period. This is a very good sign indicating each company is generating significant cash from their business operations.

Cash from investing activities includes the business activities that the company needs to remain competitive and grow the business. This includes making capital investment, acquisitions and other investments as well as sale of assets no longer needed.  For investing activities EMC is showing a cash outflow of $157 million indicating they are spending on growth opportunities. A negative number is not a sign of trouble, as long as they are generating more cash than is being invested which is the case here when comparing Cash from Operating Activities to Cash from Investing Activities.

Cash from financing activities includes the business activities finance the company. Cash from investors who have bought new shares the company has issued, borrowings and payments to banks as well as dividends are some of the items that show up in this section. Both firms reported cash outflows from their financing activities. Again a negative number here is not necessarily a sign of trouble, as long as the company is able to cover these activities with the cash they are generating. In the case of EMC they borrowed a substantial amount of money to help cover their stock repurchase program. This could be a problem if it continues as the company is replacing stock with debt. In ACN’s case they paid down some debt and bought back some stock using their available cash. The implication from this quarterly cash flow statement is Accenture is doing a better job generating cash than EMC. The conclusion is that ACN is a better buy looking at just the cash flow statement. It is always a good idea to look at other quarters to see if this is a pattern or just a one time situation.

Free Cash Flow

In the simplest form a company receives cash for what sells and then reinvests some of that cash back into the business to grow it. This is called Free Cash Flow which is operating cash flow, from the Operating Cash flow Segment minus the money spent on capital expenditures and acquisitions from the Investing Activities section of the Cash Flow Statement. Free cash flow is not shown on any statement, so you need to calculate it. Good companies generate free cash flow, meaning they have excess cash after investing in the growth of the business. This excess cash can be used to pay dividends, buy back shares, pay down debt, or saved to expand the business at a later date. Fast growing companies typically use all their excess cash to plow back into the business, so their free cash flow maybe quite small over several time periods. If free cash flow is negative, it means they are not generating enough cash from the business so they must borrow it or issue more shares. Even for fast growing businesses, this is not a sustainable situation.

In looking at their latest cash flow quarterly statements both Accenture and EMC are good companies who are generating cash. However, in this quarter Accenture generated more free cash which gives indicates that they are likely the better investment. As always it is best to examine this situation over several quarters to be sure it is not a one time anomaly or if there are other circumstances that need to be considered. Using Free Cash Flow as the only indicator would be a mistake. However, it is one of the best measures of a company’ financial performance. As a result all investors should check out the Free Cash Flow as one of the first factors they review before making an investment decision.

Conclusion

A company’s cash flow statement is one of the most reveling financial statements available to investors. It is an excellent place to start your investigation as cash is king and it is more difficult to hide problem areas of a company. Free Cash Flow is an excellent indicator of the performance of a company as it measures the actual cash an ongoing company is producing.  Become a knowledgeable investor and get to know the cash flow statement of any company you like as an investment or even an intermediate term trade.