Cash flow: A critical measure
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Karl Siegling is a portfolio manager with Cadence Capital, a listed investment company.
In our seven preceding articles for Morningstar, we have discussed the psychology of the market, as well as a number of fundamental measures commonly used by the investment industry.
This article discusses cash flow, which in our opinion, is the most important of all the fundamental measures. We will discuss operating cash flow and free cash flow separately.
Operating cash flow
Operating cash flow measures the amount of cash a company generates from its daily operations. This can be very different to the profit a company generates.
A company may sell many products in a year and offer credit to customers to buy those products, which they have purchased from suppliers. While this strategy may deliver a good profit, it does not produce any operating cash flow.
In fact, in this example the operating cash flow would be negative. The company has paid cash for goods but not received any cash in return yet.
A property trust may buy properties with debt and rent them out to tenants at yields lower than the interest rates on debt, then subsequently revalue the properties upwards by, say, 10 per cent, thus producing a "healthy" profit.
The property trust in this example would in fact produce a negative operating cash flow. Rent received would be lower than interest paid and the property revaluation produces no cash.
You often hear investors say "cash is king," and in the end, cash is king. If a business does not produce cash flow then there is a good chance it will not be around in the long run. This is why we pay particular attention to big differences in reported profits and reported operating cash flows.
One of the most useful things all of our portfolio managers do is to reconcile profit to operating cash flows. This process can help prevent large investment errors.
At a basic level, the process of reconciling cash flows to profits involves a closer look at revenues, expenses, debtors, creditors and inventory, or stock in hand. Large discrepancies in these numbers can often spell trouble, or at the very least, they need to be carefully explained by management.
Free cash flow
Free cash flow is derived from the operating cash flow outlined above and then takes into account major expenditures on, for example, property, plant and equipment, the purchase or sale of a business and major expenditure on maintaining or growing business assets.
The distinction here is that even though a business may produce good operating cash flows from its daily operations, the cost of maintaining or buying new equipment, say, every five years, may actually turn a business with good operating cash flows into a business that loses money at the free cash flow line.
Conversely, a business that makes only moderate operating cash flows but employs little to no capital in making those operating cash flows may actually produce an acceptable free cash flow.
It is important to understand whether the big capital investments made to generate an operating cash flow actually exceed that cash flow or provide sufficient return to justify the capital investment.