By elmads

One of the reasons why we work is to acquire money in order to sustain and add value to our life, including our family’s lives as well. That is why most of us seek employment to have a stable source of income. A path which majority of us undertake. A person who handles well their flow of money will more likely have a good and stable outcome in their financial lives.

This holds true for companies as well. We look into the money flow of these companies to see if they have sustainable and consistent cash flows. This is one of the criteria we research, and analyse before we invest in ta company’s stock.

This is the reason why cash flows are very important when valuing a company. Because the money we receive from the stock investments we have, depends on the company’s free cash flow.

Cash flow

Cash flow is the representation of where the money goes; from the beginning, upon receiving the money, through the end, where money is either saved or spent. This is where budgeting strategies comes in, to show where our money goes instead of wondering where it went, see my blog title “Do-It-Yourself Budgeting for everyone”. It is a tracking method of an individual’s cash flows, just like the cash flow statement in every company’s financial reports.

Every person in this earth has mostly the same process of how their cash flows.

• Income received
• Pay for basic necessities of life
• Pay debt (if we have one)

The cash left is considered as free cash to be used (either for personal expenses or savings)

Free Cash to be used = Income received – Essential Expenses – Debt (if no debt then that’s better!)

This formula is similar in a way, to a company’s cash flows but in a more complex structure.

This is the reason why the cash flow statement has been one of the focus statements for valuing companies, because what is important is the main money that went in and out of the business at a given point in time, not what the accrual accounting shows in the income statement. In this blog I will be breaking down further how to arrive into a company’s free cash flow with an analogy to an individual level.

The Free Cash Flow of a company

Just like what I have discussed in my blog titled “Stocks and Shares”, stocks and shares are a piece of ownership of a company or group of companies.

That in mind, when the companies continue to grow and expand, so does the returns of their investors. This returns do not come directly from the net income of the company which is found in the income statement but from the company’s free cash flow.

In finance, free cash flow is very important because this is the cash that can be used by the company to either further grow and expand the company through reinvestments or to be given out to their investors via dividends. This means that technically, Free Cash Flow is the money for us investors/shareholders. It is just like an Individual’s Free Cash Flow, in which we can choose for ourselves where we could allocate that free cash that we have after paying all of the essential expenses to sustain our lives.

To arrive into the free cash flow of the company, we need to undergo a simple computation;

1. Net income (found in the income statement)
2. Add non-cash expenses (depreciation & amortization, found in the income statement)
3. subtract change in non-cash working capital (found in the balance sheet)
4. subtract capital expenditures (found in the cash flow statement)

If you find it hard to look and compute for the above formula, don’t worry because there is an easier way.

Go into the company’s Cash Flow Statement > look for the Total generated cash from operating activities or also known as cash from operations > then subtract Capital Expenditures which is found in Cash Flow from Investing activities section. The amount will be the company’s Free Cash Flow that they can use to pay debt, reinvestment in order to grow the company or give it to their shareholders through dividends.

Free Cash Flow = Total Cash from Operating Activities – Capital Expenditures

So as indicate in the slideshow photograph above, Apple inc’s 2020 Free Cash Flow is $39,867 Billion, which they can use

• to pay their debt
• buy back some of their company stocks in the stock market
• give to their investors as dividends
• reinvest it back to the company to reinvest it into more projects to spur expansion and growth.

Maybe you are wondering what did Apple do with the Free Cash Flow that they had during that time. Well they only did 3 methods that I mentioned above.

• They paid some of their debt : $5,250 billions
• They bough back some of the company shares : $39,280 billions worth of shares
• Gave dividends to their investors : $6,914 billions

Total amount shelled out was $51,444 billion

All in all, they paid more than their Free Cash Flow amount for 2020. So how did apple pay more than their Free Cash Flow (FCF)? we have to take into account that they still have capital left from their previous debts, they also acquired additional financing through debt in 2020 plus they used their saved previous earnings (also called as retained earnings which can be found in the balance sheet) not just to pay debt, buyback shares, pay as dividends but also to purchase assets that will grow their company.

NOTE: Some companies acquire debt not because they need capital, but for tax incentive.

I did not made this up. The numbers told the story to me, it talks and communicates to the person who know their language. This is the wonder of learning fundamental analysis and basic accounting. It paints the picture of the company’s finances.

If you want to Confirm all of the information I gave, check Apple Incorporation’s financial 10K financial report in the link provided below

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The basic pathway of a company’s free cash flow

Upon receiving their revenue,

1.) Companies will then need to pay for their operating expenses such as utilities, insurance, marketing expenses, rent and employee wages.

2.) Just like anyone else in this world, companies will also need to pay taxes for their operations

3.) Furthermore, money for working capital is included as well. This is the capital needed for the company to run their business operations within the year, included here are the amount of inventory of a company which are the products the company will sell to the consumers (in particular, supermarkets in which their inventory of goods are being sold to the consumers.), the amount receivables which are owed by consumers to the company as a credit, and the amount payables which are the owed money by the company to its suppliers via credit too.

4.) Then for capital expenditures, these are essential for the company’s operations to maintain their properties, plants, and equipment.

After, deducting these basic 4 and adding depreciation and amortization, we will arrive into the company’s free cash flow.

To sum it up

On an individual level, the importance of finding what is the free amount of money that we can use for either our personal wants, savings and investment is to project the future amount that we can save and invest down the line.

It is the same with company valuations. The future return of an investor depends on the company’s free cash flow as what I have discusses and showed you in this blog. That is why free cash flow is the most important number in analysing companies. This dictates our current and future returns, by knowing the past to present free cash flow of the company. It is here that we will be able to arrive into an intelligent calculation of the future free cash flow that they could probably generate, then we discount it back to the present value of that future cash flow, by doing this we will find the intrinsic value of a business.

“𝗘𝗻𝘁𝗿𝗲𝗽𝗿𝗲𝗻𝗲𝘂𝗿𝘀 𝗯𝗲𝗹𝗶𝗲𝘃𝗲 𝘁𝗵𝗮𝘁 𝗽𝗿𝗼𝗳𝗶𝘁 𝗶𝘀 𝘄𝗵𝗮𝘁 𝗺𝗮𝘁𝘁𝗲𝗿𝘀 𝗺𝗼𝘀𝘁 𝗶𝗻 𝗮 𝗻𝗲𝘄 𝗲𝗻𝘁𝗲𝗿𝗽𝗿𝗶𝘀𝗲. 𝗕𝘂𝘁 𝗽𝗿𝗼𝗳𝗶𝘁 𝗶𝘀 𝘀𝗲𝗰𝗼𝗻𝗱𝗮𝗿𝘆. 𝗖𝗮𝘀𝗵 𝗳𝗹𝗼𝘄 𝗺𝗮𝘁𝘁𝗲𝗿𝘀 𝗺𝗼𝘀𝘁.”

-𝗣𝗲𝘁𝗲𝗿 𝗗𝗿𝘂𝗰𝗸𝗲𝗿

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.