Cash flow and free cash flow

Earnings are an opinion; cash is a fact. The income statement records revenue when it is earned and costs when they are incurred, which is sensible accounting but leaves room for judgement. The cash flow statement records money that actually moved. When the two disagree for long, cash is usually the one telling the truth.

The three sections

The cash flow statement has three parts, and the sign of each tells a story.

A healthy mature company usually has positive CFO, negative investing (it is spending on its future), and negative financing (it is returning money to shareholders or paying down debt). A young growth company might have negative CFO, negative investing, and positive financing (it is raising money to fund both). Neither shape is good or bad by itself; the question is whether the shape fits the story management tells.

From net income to cash from operations

CFO starts with net income and adjusts for things that affected profit but not cash, and vice versa.

Depreciation is added back because it is a non-cash charge: the cash for the factory was spent years ago. Stock-based compensation is added back because it was paid in shares, not cash (though it is a real cost to shareholders through dilution). Growth in receivables is subtracted because those sales have not been collected yet. Growth in payables is added because the company has not paid those bills yet.

The ratio of CFO to net income, $330M ÷ $210M = 1.57, is a quick quality check. Above 1.0 for an established company is normal, because depreciation gets added back. Well below 1.0 for several quarters means earnings are not turning into cash, and that is the fingerprint of aggressive accounting or a business that has to keep funding customers and inventory.

Free cash flow

Free cash flow (FCF) is what is left after the company has spent what it needs to maintain and grow its operations:

FCF = cash from operations − capital expenditures = $330M − $110M = $220M

That $220M is the money available to pay dividends, buy back stock, repay debt, make acquisitions, or simply accumulate. It is the number most professional investors consider the truest measure of what a business produces, because it cannot be improved by accounting choices about when to recognise revenue or how to classify a cost.

Two related figures:

• FCF per share: $220M ÷ 100M = $2.20. Slightly above EPS of $2.10, which is a good sign.
• FCF yield: $220M ÷ $4,000M market cap = 5.5%. This is the cash the business produces per dollar of market value, the inverse of a price-to-FCF ratio of 18.2. It compares directly with a bond yield, which is why rates matter so much to valuation (module 6).

Key idea: Free cash flow = cash from operations − capex. It is the hardest number to fake and the one that funds everything shareholders receive.

When earnings and cash disagree

Here is a pattern worth memorising. Two companies both report net income of $210M.

Mirage has the same EPS, the same P/E, and it is burning cash. Its receivables grew by $140M, meaning it booked sales it has not been paid for, and its inventory grew by $95M, meaning it made product it has not sold. Either it is growing very fast and needs working capital (possible), or it is stuffing the channel and recognising revenue early (also possible). Either way, an EPS-only screen cannot tell the two companies apart. A cash flow read takes ninety seconds and separates them completely.

For a trader, Mirage carries a specific risk: businesses that burn cash while reporting profits eventually have to either raise money or restate. Both are gap-down events.

Capex: maintenance vs growth

Not all capex is equal. A company spending $110M a year, of which $80M merely replaces worn-out equipment (roughly its depreciation), is spending $30M on growth. A company spending $300M against $80M of depreciation is investing heavily, and its FCF looks worse today so that its revenue can be larger later. Filings and earnings calls usually separate the two. When capex rises sharply, the question to ask is whether revenue growth follows within a few quarters.

What a trader takes from the cash flow statement

1. Is CFO positive and at least comparable to net income? If CFO ÷ net income is under 0.7 for several quarters, be suspicious of the EPS.
2. Is FCF positive? If not, how many quarters of cash does the company have (cash ÷ quarterly burn)? Under four quarters means an offering is likely.
3. What is the company doing with FCF? Buybacks support the stock; debt repayment reduces risk; large acquisitions add goodwill and integration risk.
4. Is capex rising faster than revenue? If so, either growth is coming or money is being wasted; find out which from the call.

Try it: For any company, compute CFO ÷ net income and FCF for the last four quarters. If the company reports a large gap between adjusted EPS and GAAP EPS, check whether that gap also shows up as a gap between net income and CFO. It often does not, and the reason is usually stock-based compensation.

Recap

• The cash flow statement records money that actually moved: operations, investing, financing.
• CFO ÷ net income well below 1.0 for several quarters is the fingerprint of earnings that are not turning into cash.
• Free cash flow = CFO − capex. It funds dividends, buybacks and debt repayment and is the hardest number to manipulate.
• Two companies with the same EPS can have opposite free cash flow; only the cash flow statement tells them apart.
• Cash burners with under four quarters of runway are likely to raise equity, which is a gap-down event.