Any investor has to understand and evaluate company’s Free Cash Flow.
When I was younger, a lot younger in school, in order to teach me financial and economical terms they used to compare it with a normal family situation.
Today, my idea, to the ones interested in understanding better Free Cash Flow, is to do the same and compare it with the income and costs of a normal middle class family.
Business vs. Family
Here how I would compare Business vs. Family:
- Revenue = Family Income (Mother and Father’ salary, some additional income from investment, like an appartment, savings or a fund)
- SG&A = Cost of living (supermarket, school, insurance, pharmacy, utilities’ bills…)
- Operating Cash Flow (OpCF) = the difference of the first two
- CAPEX = House Investment (fix the roof, add solar panel, and any other investment that usually allows you to contain or reduce costs)
- Free Cash Flow (FCF) is now the difference between OpCF and Capex.
So with the FCF a family can now:
- pay Debt(if they have house mortgages or car lease)
- pay the additonal investment, (especially if you are your own employer or you have a house)
- but more important you can add it to your savings and pay yourself with some little extra presents
So, as for any family for a business it’s important to have High Free Cash Flow and low debt. The higher is the FCF the more you can accumulate saving or you can spend in extra (nice holidays).
You will find company or industries with very high OpCF, but weak FCF, limiting the distribution to their shareholders. In order to avoid this, I started to look for industries and company very cash effective, as they don’t need much for CAPEX. Industries like Consumer, Software, Insurance or companies like Microsoft, Cisco, AXA are excellent examples.
Historically very cash demanding industries are Automotive, Telcos (as they have to pay in advance for the spectrum and installation). However, as for Mr.Marchionne presentation (Confession of a Capital Junkie) the automotive business is moving in the right direction and trying to keep more and more OpCF for its own shareholders. Also Volkswagen for necesity is forced to improve this KPI in order to save as much as possible and be able to cover the cost of its latest suits.
It’s crucial to analyse not only Company profitability, but also it’s Capital Effectiveness. Don’t buy a business that can only distribute a limited part of its own profit to the shareholder. You want management to maximize FCF, generating high savings, dividends and even Share Buy Back.