Free cash flows

Free cash flow is the cash a business has left after it has paid its operating costs and its tax, and made the investment it needs to keep trading and to grow. Nobody inside the business has a further claim on it, which is what makes it free — it can go to the people who funded the business.

That is why it tells you more than profit does. Profit is struck after non-cash charges like depreciation and before the capital spending that keeps the machinery running, so it can move in one direction while the bank balance moves in the other. Cash cannot. A company can report a rising operating profit for three years and still run out of money.

The gap is easy to see in a Zambian milling business. It sells maize meal to wholesalers on 60-day credit, books the revenue and the profit the day the truck leaves, and then has to find cash for the ZESCO bill, the fuel and the next consignment of grain before a single customer has paid. The profit is real. The cash is somewhere else.

You build free cash flow out of the accounts. Start at operating profit before interest and tax, then correct it for everything the accounts recorded on a basis other than cash.

• Depreciation is added back because no money moved. It is the accounts spreading the cost of an asset over its life, not a payment made this year.
• Tax is deducted at the amount actually paid, because that money genuinely leaves.
• Replacement investment keeps the existing assets working. A business that stops replacing them is quietly shrinking, so this spending is not optional.
• Incremental investment in non-current assets buys the extra capacity that growth needs.
• Incremental working capital is the stock and the receivables that growth ties up before any customer pays.

Interest is nowhere in that working, and its absence is the point. This is cash to the firm as a whole — to lenders and shareholders together. Deducting interest here would pay one group of investors before you had finished measuring what there is to share.

Free cash flow to equity is what is left for shareholders once the lenders have been paid everything they are owed this year. You get to it by carrying on from where the last working stopped.

New borrowing is added rather than ignored. It is cash arriving in the business that the shareholders can use this year, even though it will have to be serviced and repaid later. A company that repays ZMW30 million of old loans and draws down ZMW30 million of new ones has moved no cash at all, and the working should say so.

Because it is the shareholders’ cash, free cash flow to equity is the honest way to test whether a dividend is affordable.

A cover of 2 means the company generated twice the cash it handed out. Below 1 means it paid dividends it had not earned in cash, and funded the difference from reserves or from borrowing. The same company measured on earnings can look comfortable, because earnings never had the capital spending taken out of them.

Free cash flow does three jobs, and which of the two measures you reach for follows from the job in front of you.

• Appraising a project — the free cash flows the project itself generates are what get discounted to find its net present value.
• Reading a company’s health — a business whose free cash flow has turned negative while its profit holds up is the classic early warning, which is why the measure is central to work on corporate failure and reconstruction.
• Valuing a business — the value of a company is the present value of the free cash flows it will produce, so this is where a share price comes from.

The pairing is not a convention to memorise — it is a matching rule. Cash that belongs to everybody is discounted at a rate that reflects what everybody demands. Cash that belongs to shareholders alone is discounted at what shareholders alone demand. Mixing them values a company at a number nobody could ever collect. Where those two rates come from is the whole of Lesson 2.

A company reports the following for the year. Calculate its free cash flow to the firm and to equity.

Work to the firm first, and leave the interest and the loan repayment out of it — they belong to the second stage.

Now take the lenders out to reach the shareholders.

Read what the two figures say. The business generated ZMW205,000 for everyone who funded it. After servicing its debt, ZMW180,000 of that belonged to shareholders — so a dividend of ZMW90,000 would be covered twice over, and a dividend of ZMW200,000 would have to come from somewhere other than this year’s trading.