Free Cash Flow: A Complete Guide to Understanding FCF

The current article explains the concept of Free Cash Flow (FCF), its importance in investment decision-making along with illustrative examples of companies with a positive free cash flow and with a negative cash flow. The article also includes responses to the queries asked by readers about various finer aspects of Free Cash Flow analysis.

What is Free Cash Flow (FCF)

We believe that free cash flow (FCF) is the ultimate measure of investability of any company. It is calculated as the surplus cash with the company after meeting its capital expenditure requirements. 

FCF = CFO – Capex

Where,

• CFO = cash flow from operations
• Capex = capital expenditure including maintenance capex and capital work in progress (CWIP)

Capex for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at the start of the year and the end of the year. It can also be calculated by deducting net fixed assets & CWIP at the start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year. 

Capex:

(GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year

OR

(NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the year

Free cash flow (FCF) is the most essential feature of any business as it amounts to the surplus/discretionary cash that the business/company is able to generate for its shareholders. FCF is the equivalent of savings for a household.

If we as households are not able to manage our expenses within our means of income, i.e. are not able to save anything, then our financial health is going to suffer a lot in future. We would have to borrow from relative/banks etc. to meet our requirements. The debt, which we raise to fund our expenses, needs to be paid at predefined intervals irrespective of the fact whether we are able to save in future/have our job intact or not. Debt pressure increases the bankruptcy risk and leads to stress in our lives.

The scenario is exactly the same for companies as well.

If a company does not have positive free cash flow, it means that it is spending beyond its means. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. These funds, if raised from debt, would decrease profitability by interest expense and increase bankruptcy risk and if raised from equity, would lead to dilution of the stake of existing shareholders.

In both the cases, the situation of companies continuously raising debt/equity to meet their cash flow requirements becomes less attractive for investors as compared to the companies that are able to meet their funds’ requirements from their cash flow from operations.

It might be argued that the investments done today by the company would lead to revenue & profits in the future and would generate wealth for the shareholders.

This argument is a valid argument just like an educational loan for an individual. An education funded by a loan is an investment, which has the potential of increasing the skills set, earning ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies, the investment in plants & machinery and technology is like an educational loan, which increases future earnings potential. Therefore, we should not worry about the situation where a company is not able to generate positive FCF for a few years. Such companies might be taking education loans to generate future wealth. However, if a company is not able to generate positive FCF over long periods of time (I assess them over the last 10 years), then the company resembles a continuous cash guzzling machine.

It resembles an individual who is continuously garnering degrees after degrees costing millions of rupees/dollar, without ever putting those skills to commercial use. Or those degrees might be fake and cash has already gone down the drain! In both cases, the investment done is not of much use.

I, as a shareholder, expect the companies I own, to be cash-generating machines. Their business should be a source of cash for me and not the other way round. Therefore, positive free cash flow generation by a company over the last 10 years, is one of the key criteria for stock selection for me.

In our assessment of the margin of safety in any stock investment, free cash flow plays an important role.

Free Cash Flow and Margin of Safety

I find that the companies, which have achieved their sales growth in the past by using the minimum amount of CFO as capex have a significantly higher margin of safety over the companies which have used almost all CFO. Needless to say, the companies, which have their capex much higher than their entire CFO over the last 10 years (i.e. negative FCF), have very low/negative margin of safety.

An illustration of the importance of free cash flow:

Let’s take an example of two similar-sized companies (A & B) growing their sales at a similar rate (say 15%) in the past. Let’s assume that both the companies A & B, generated the same amount of CFO over the last 10 years (say ₹100 cr).

Let’s assume that on analysing the capex done by these companies in last 10 years, we find company A has achieved the sales growth (15%) by doing a capex of ₹50 cr (50% of CFO), thereby, generating an FCF of ₹50 cr. On the contrary, we find that the company B has achieved the same sales growth (15%) by doing a capex of ₹100 cr (100% of CFO), thereby, generating NIL FCF.

When the tough times strike the economy in future, the profitability of companies would decline, customers would delay the payment of cash, suppliers would ask for immediate cash and the credit from all sources would become costly.

In such a situation, company A, whose business model permitted it to achieve the sales growth by using only 50% of CFO in the past, would be able to bear the impact of reducing cash inflows as customers cancel their orders, squeeze profit margins and delay the payments. Theoretically, company A can tolerate its profitability and cash collections (CFO) declining by 50%, before signs of stress start becoming visible on its business operations & planned investments.

On the other hand, company B, which was already investing 100% of its CFO to generate its sales, would find even the slightest decline in its cash flow (CFO), impacting its operations. Declining orders, reduced profitability and delayed payments from customers would make it difficult for company B to make payments to its suppliers and do planned investments. Company B would have to rely on additional debt/equity raising to fund its cash requirements.

If there is another company C, which was already using more than 100% of its CFO in capex, thereby having negative free cash flow (FCF). Such a company would already be sagging down under a lot of debt burden. In a tough economic situation described above, company C would find it difficult to continue its business operations as usual as sources of cash dry up. The additional debt, which was essential to sustain its business model, would become further costly.

Companies like C are prime candidates for bankruptcy in tough times as they find it difficult to service existing debt, make payments to suppliers. Such companies, usually being capex heavy and operating at low-profit margins, find it difficult to garner additional business by reducing their profitability as it would push them into losses. Such companies rarely have any margin of safety built-in their business model.

Let us see the real-life examples of companies with different levels of free cash flow (FCF) generation:

1) Positive Free Cash Flow:

Honeywell Automation India Ltd is a part of Honeywell group, USA, is its Indian subsidiary working in automation and control systems in industries, buildings, automobiles etc. It is a prime example of a company, which has been able to generate a lot of free cash flow from its operations over the years.

Over the last 10 years (FY2010-2020), Honeywell Automation India Ltd has generated cash flow from operations (CFO) of ₹1,501 cr. whereas it needed to invest only ₹294 cr. in its business and thereby leaving ₹1,207 cr. in the hand of the company as discretionary cash to reward its shareholders. No wonder that the company could provide dividends to the tune of ₹198 cr. over the last 10 years and still increase its cash & investments by more than ₹1,000 cr over the last 10 years.

In addition, the company is virtually debt-free. The liability of ₹81 cr shown in FY2020 is due to changes in the accounting treatment of leased assets where now, the lease liabilities are shown as debt.

Honeywell Automation India Ltd presents an example of a very attractive business, which offers 80% of the cash generated to its owners as free cash without compromising on its future growth. This represents a huge amount of margin of safety built into the business.

During tough times, Honeywell Automation India Ltd can reduce prices of its services, offer higher credit period to its customers, pay its vendors promptly to attract and retain quality suppliers without impacting its balance sheet. It would not need to raise debt for such crisis strategies; only a slight reduction in the dividend payouts to the shareholders would provide enough money to fund the emergency measures.

No wonder, the market loves it and its shares trade at P/E ratio in the 50s.

An investor may read our detailed analysis of Honeywell Automation India Ltd in the following article: Analysis: Honeywell Automation India Ltd

2) Negative Free Cash Flow:

On the contrary, we can see the example of Filatex India Ltd, an Indian manufacturer of polyester, nylon & polypropylene multifilament yarn, which has been acting as a cash guzzler for its shareholders.

Over the last 10 years (FY2011-20), Filatex India Ltd has generated cash flow from operations of ₹791 cr. However, its business required it to invest ₹1,298 cr in the company, thereby eliminating any chance of free cash flow. The company had a negative free cash flow of about ₹507 cr over FY2011-2020.

Filatex India Ltd had to raise debt of about ₹640 cr to fund its capital expenditure requirements. Total debt of the company increased from ₹81 cr. in FY2011 to ₹720 cr. in FY2020. In addition, it raised about ₹100 cr from equity issuances in the last year so that it could make the investments needed for its sales growth aspirations.

An investor may read our detailed analysis of Filatex India Ltd in the following article: Analysis: Filatex India Ltd

If the economic scenario deteriorates further, then the company would have to meet its cash requirements by raising further debt or equity. Incase its lenders or shareholders, do not provide this capital, then the company would face a difficult time to tide over the crisis.

Looking at the above situation, it is clear that Filatex India Ltd does not have a significant margin of safety built into its business model.

Therefore, an investor can see that positive FCF is an important parameter for investment and the fact that the higher the FCF as a proportion of CFO, the higher the margin of safety.

Advised reading: Margin of Safety in Stock Investing: A Complete Guide

Should we reject companies with a negative Free Cash Flow straightaway?

From the above discussion, an investor would notice that the companies with a positive FCF come across as the ones with a good and stable financial position. However, it does not mean that an investor should reject any company with a negative FCF straightaway even if other parameters show that it has a fundamentally sound business model. The answer is, No!

This is because when an investor looks at the formula of FCF (= CFO – Capital Expenditure), then she would notice that instead of a weak CFO, a large capital expenditure (Capex) may be the reason for negative FCF. Moreover, a large capex may be a result of excellent investment opportunities available for the company in its business. As a result, the company may be striving to grow its business fast to capitalize on the available opportunities.

In our attempt to analyse all the companies listed on India stock exchanges, when we looked at the financial performance of more than 2,800 companies above a market capitalization of ₹10 cr, then we came across many companies which had grown their business significantly and as a result, they had a negative free cash flow. At the same time, these companies rewarded their shareholders by the way of a significant increase in their share price because they kept the debt levels within control and improved their business strength.

Read: What I learnt from brief analysis of 2,800 Companies

7) Many large companies keep rewarding shareholders by way of increase in stock market price despite nil or negative free cash flow:

During the analysis of many large companies, I noticed that the stock price of these companies had witnessed a significant increase over the last 10 years where these companies had nil or negative free cash flow. In many cases, these companies had resorted to funding this cash flow gap by taking additional debt. However, in almost all the cases, the debt raised was small and within easily serviceable limits.

An investor would appreciate that the final investment decision by any investor is a result of a combination of all the parameters like financial, business, management and valuation analysis. Therefore, even in the case of companies with a negative FCF, if the investor notices that they have strong performance on other parameters and their debt level is under control, then she may look at these companies for investment instead of rejecting them straight away due to negative FCF.

Let us now further understand the concept of FCF by looking at different practical aspects:

Answers to Readers’ Queries on Free Cash Flow

FCF vs Net Cash Addition

Hello Dr Vijay,

1. In our analyses, we have always stressed a positive FCF over the years as a good health indicator for a company. However, we consider only CFO and capex for the calculations. Why is our cash-health analysis complete with the above two factors alone? Shouldn’t nets of CFO, CFI and CFF all be taken into consideration?
2. If there is a considerable difference between cumulative capex and CFI, why do we consider capex and not CFI?
3. What is the actual cash available (not necessarily liquid) to the company? Is it cumulative net cash flow or cumulative FCF?
4. In the below example of Hind Zinc, the FCF is around 30K CR, the Net cash flow cumulative is 7 CR. What is the significance of this difference? The company still took a debt of around 8K CR in spite of having an FCF of 30K CR. May you please help in understanding this scenario?

Here’s an example of Hindustan Zinc Limited (HZL):

Whereas the net cash flow represents a very different picture:

Even by only considering CFI with CFO, net CFI is 27k cr whereas capex is 15k cr.

Thank You in Advance!

Best Regards,

Shreyas

Author’s Response

Hi Shreyas,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts. Let us attempt to answer your queries one by one:

1. In our analyses we have always stressed on a positive FCF over the years as a good health indicator for a company. However, we consider only CFO and capex for the calculations. Why is our cash-health analysis complete with the above two factors alone? Shouldn’t nets of CFO, CFI and CFF all be taken into consideration?

A calculation of free cash flow (FCF) by using cash flow from operations (CFO) and capital expenditure (capex) i.e. FCF = CFO – Capex, is helpful in assessing the ability of the business to produce surplus discretionary cash for its stakeholders. FCF is the net cash generated by any business after meeting all the capital expenditure requirements. It means that the capex, which is deducted from CFO includes the maintenance expenses, which is needed to run its existing manufacturing plants smoothly (i.e. maintenance capex) and also the growth capex, which is needed to create new manufacturing plants to achieve future growth.

Therefore, Free Cash Flow (FCF) analysis (= CFO – Capex) intimates an investor whether a company is able to generate discretionary surplus cash or not. FCF is the extra cash, which a company may use for activities like acquisitions of other companies, investment in fixed deposits (FDs) or mutual funds (MFs), repay existing loans, pay dividends or buyback shares from its shareholders. An investor would note that a company will find it difficult to do all these above-mentioned activities in case it is not generating free cash flow (FCF).

Further, an investor would also notice that the above-mentioned usages of surplus cash (FCF) are shown in the financial statements of any company under either cash flow from investing (CFI) or cash flow from financing (CFF). For example, cash used in acquisitions of other companies, investment in fixed deposits (FDs) or mutual funds (MFs) etc. is shown under CFI whereas the cash used in repayment of existing loans, payment of dividends or buyback of shares is shown under CFF.

We believe that if an investor focuses on net cash generated after CFI and CFF i.e. (CFO +/- CFI +/- CFF) instead of free cash flow (FCF = CFO – Capex), then she would not be able to assess the real surplus cash-generating ability of the business. This is because, even in the cases of companies with high FCF, the surplus cash of the company would already have been utilized/invested in FD, MF (CFI) etc. or in dividends, buybacks (CFF) etc. and no significant amount of net cash would have left in hand. Therefore, if an investor focuses only on net cash after CFI and CFF, then she may erroneously conclude that this company is not able to generate any cash.

We can understand it further by taking an example of any common household where some of the members earn salaries and use it to spend on different expenses like household expenses, children education etc. Every month, the surplus cash remaining after meeting the expenses is invested in assets like FDs, MFs, PPF and Stocks etc. and some amount of money would be kept at home to meet small cash expenses.

In the case of such a household, the free cash flow (FCF) would be equal to surplus cash left from salary after meeting expenses. Whereas, the net cash generated would be the cash kept at the house after investing money in FDs, MFs, PPF, Stocks etc. We believe that to assess the true surplus cash-generating ability of this household, an investor would need to focus on FCF (i.e. salary – expenses). If she focuses on net cash after its investments, then she might erroneously conclude that the household is not saving any money, which is not the case.

When we extend the same argument to companies, then we find that the FCF of any company (=CFO – Capex) is the key parameter to ascertain the surplus cash-generating ability of the business. The net cash generated after CFI and CFF is the residual value left after a company has used it FCF in the manner it deemed fit like investing in FD, MF, subsidiaries etc. or repayment of loans, dividends, share buybacks etc.

Therefore, in order to ascertain the fundamental strength in the cash flow of any company, we prioritize CFO as one of the key parameters.

Advised reading: Key Parameters in Assessing the Margin of Safety in a Stock

2. If there is a considerable difference between cumulative capex and CFI, why do we consider capex and not CFI?

As mentioned above, the cash flow from investing (CFI) would represent capex as well as other utilizations of the FCF like investments in FDs, MFs, Stocks, acquisitions etc. Therefore, if we deduct entire CFI from CFO to assess surplus/free cash generation, then we might make errors in calculating the fundamental strength of the company. Therefore, we believe that investors should make a case to case decision by looking at each of the items of the CFI.

3. What is the actual cash available (not necessarily liquid) to the company? Is it cumulative net cash flow or cumulative FCF?

As mentioned above, the actual cash available from the business to the company, which it can use for other activities like investments (FD, MF etc.), repayment of loans, dividends, buybacks etc. is the free cash flow (FCF = CFO – Capex).

4. In the below example of Hind Zinc, the FCF is around 30K CR, the Net cash flow cumulative is 7 CR. What is the significance of this difference? The company still took a debt of around 8K CR in spite of having an FCF of 30K CR. May you please help in understanding this scenario? Here’s an example of Hind. Zinc where the net cash flow represents a very different picture. Even by only considering CFI with CFO, net CFI is 27k cr whereas capex is 15k cr.

We believe that whenever an investor comes across questions upon looking at the financial data, then the first source to look for answers should be the annual report. This is because most of the times, the annual report contains details of the decisions and the steps taken the management during the year, which provide explanation/answers to investors’ queries. Reading the annual report is an essential exercise because the financial numbers in excel cannot provide descriptive information about the company, where the annual report becomes helpful.

In case of Hindustan Zinc Ltd (HZL), if an investor reads the annual report for FY2017, page 69, then she gets to know that the company has paid out about ₹15,000 cr as dividend to shareholders.

Therefore, combining the learning from the excel data and the annual report, an investor would note that in FY2017, Hindustan Zinc Ltd (HZL) generated a CFO of about ₹7,500 cr., did a capex of ₹2,000 cr resulting in a free cash flow (FCF) of about ₹5,500 cr. As the company paid out a dividend of about ₹15,000 cr, therefore, it used debt to raise money to meet this large dividend payout. As a result, investors would notice that the debt of HZL in FY2017, increased from “nil” at the start of the year to about ₹8,000 at the end of the year.

Therefore, we believe that investors should always combine their learning from the financial data in excel with the learning from the reading of the annual report. Upon the combined assessment of excel and the annual report, the investor would be able to get the answers to most of her queries.

Advised reading: Understanding Annual Report of a Company

An investor may also note that in case of the data provided by Screener through the export to excel feature, for many companies, the financial data of last 2-3 years does not include the data of dividend payouts. Therefore, reading the annual reports becomes quintessential for getting a complete picture of the fundamental business of companies.

Hope it answers your queries.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Why do companies with negative free cash flow pay dividends out of debt?

Hi Dr,

I found it interesting to find you, a medical person, so methodical & scrupulous in accounting.

Overall, I have learned some fundamental principles of accounting, reading BS, PL account. Now I am confident of reading annual reports, which earlier I used to shun away as I am from a science background.

I would request you to clarify the following:

In companies with negative free cash flow (FCF), which have taken debt to fund their expansion projects, we assume that the dividends are also funded out of the debt. I wish to know why did that promoter take debt to give out dividends. Is it just to create a rosy picture? In addition, how did bankers or financiers kept on funding? They must be clever than a poor retail investor!

Author’s Response:

Hi,

Thanks for writing to us! We are happy to know that you found the workshop value-adding.

One of the reasons for promoters to give dividends despite poor operating cash flows can be that they would be the largest beneficiary of such payments considering that promoters are the largest shareholders of the company. Bankers might have kept on funding assuming that in future the business cycle will revive and the company might make up for all the interest payments and loan repayments etc.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

All the best for your investing journey!

Regards,

Dr Vijay Malik

Why would a company with positive free cash flow have high debt?

Hi Dr Vijay,

I have recently discovered your website and cannot put into words how much I am learning every day by simply reading your various blogs/articles.

Recently I started reading about the Margin of Safety/FCF/SSGR concepts you have written about which make so much sense.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

I have a couple of doubts after reading these articles that I have not been able to fully figure out on my own. Hence requesting if you could kindly help throw some more light on it.

1. Self-sustainable growth rate (SSGR) looks at obviously the ability of the company to grow its business in terms of topline and hence probably differs from other profitability metrics like RoE which focus almost always on the bottom line. Why do you focus on the top line? Esp. when topline can be influenced by many exogenous factors, like say, in the case of companies which use crude derivatives (e.g. Aarti Industries). In such cases looking at top-line growth may not give the correct picture I think. Can you please comment on this?
2. Does looking at free cash flow (FCF) alone give you the full picture of whether the company will need to resort to debt in order to grow? For example, I have found a number of cases, where despite FCF being +ve over 10 yrs, the debt has grown significantly. What are the reasons this can actually happen?

I found that one reason could be that the company is borrowing money to pay interest and dividends etc. and it gets into a loop: take new debt to pay off old debt. One example again I can quote is of Aarti industries. Can you please comment on this as well?

Thank you so much in advance.

Warm regards,

Author’s Response:

Hi,

Thanks for your feedback! We are happy that you found the articles useful!

SSGR provides an output as the top line growth but it has NPM has a constituent parameter (referring to the formula):

SSGR = NFAT*NPM*(1-DPR) – Dep

SSGR effectively tells an investor the sustainable growth rate assuming constant NPM i.e. PAT is also expected to improve in line with sales growth. If the NPM improves/declines for the company, the SSGR will improve/decline as well.

FCF positive companies having a high debt is something, which should always be explored further. It might be that money is being diverted from the company as loans & advances to other companies, unaffordable dividends etc.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

Why would a company with positive free cash flow not repay debt and become debt free?

Sir,

I have come to a scenario where SSGR is 8-9% and 10 Yr sales growth is 13%…it looks like less MoS but at the same time company have CFO 572 cr of 10 Yr and 10 Yr capex is 361cr so FCF of 212cr of 10 yr. the company paid 42 cr in dividend but at the same time, the debt level has increased in 10 Yrs from 112 cr to 208cr. but D/E is 0.5, so I am confused here at p/e13, d/e 0.5 and SSGR < sales growth and having positive FCF and FCF to CFO is 37%, do this company have any margin of safety?

Read: Finding Self Sustainable Growth Rate (SSGR): a measure of Inherent Growth Potential of a Company

One more thing if the company have FCF of 211cr as FCF, then why it is not paying entire debt and become debt-free and 1 or 2 Yr no need to give a dividend. Anyway, I try to find this answer in AR but I would like your view on the same.

The company name is: Mirza international

Author’s Response:

Hi,

Thanks for writing to us.

Mirza international has already been analysed on the blog in response to a reader’s query. You may read it here:

Read: Analysis: Mirza International Limited (Red Tape Shoes)

FCF does not factor in interest payments as interest payment is part of cash flow from financing. The total P&L interest expense of Mirza International for 2007-16 is Rs. 237cr. which leaves little money for debt reduction. Instead, the FCF being Rs. 212 cr. is not sufficient to meet the interest expense and the company has to take additional debt (Rs. 93 cr.) in the last 10 years to service the interest and pay dividends.

Hope it answers your concerns.

All the best for your investing journey!

Regards

Follow up query: Should we deduct Interest Expense to calculate FCF?

If only counting cFCF is not sufficient to explore actual financial health of the company over a time then while counting cFCF by deducting cCAPEX from cCFO, why we are not using cCFO-cINTEREST OUTGO?

Means NET FCF = (cCFO-cINTEREST OUTGO)-CAPEX ?

As only watching D/E ratio doesn’t reflect the rollover of its debt, on calculating in this format we can become aware of the fact that company is doing rollover of its debt to fulfil its sales growth, working capital, its maintenance capex, its dividend payout etc. Am I right or missing something?

Author’s Response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to deeply understand different concepts.

As mentioned in the article above, we use FCF to understand the fundamental cash-generating ability of the business. FCF indicates the ability of the business without getting influenced by the financing arrangements used to fund the business.

If we use FCF-interest outgo, then we combine the characteristics of the business and the management executive decision of financing into one step. We keep these things separate in our assessment and combine their learnings in our analysis while we incorporate learning of multiple other parameters like management analysis, valuation analysis, operating efficiency etc.

As the final investment decision is a combination of the learning of all the parameters, therefore, the FCF as well as the interest outflow etc get factored in the final assessment.

However, as finance & investments allow every investor to tweak the processes and the ratios as per their preference, therefore, we believe that in case, an investor believes that combining FCF and interest outgo in one parameter is more efficient, then she may use it in her stock assessment framework. She may use it on multiple cases and then decide whether it gives her the desired results and then she may take her decision.

In our stock assessment, though we factor in both the FCF as well as interest expenses, however, we do not combine them in one parameter. We assess them separately due to the reasons mentioned above.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr Vijay Malik

How to interpret a negative capex amount?

Hello Dr Vijay,

I have been using your excel template for analysis of the stocks.

Dr Vijay Malik’s Stock Analysis Excel Template (Compatible with Screener)

Sometimes I find that the capex value is in negative. Could you please provide some details about what does a negative capex value mean? Or it is because of some formula limitations. I was analyzing Shree Pushkar Chemicals & Fertilisers Ltd and for March 2015, it gave me a capex of -1294.

When we calculate 10-year capex, then because of this negative capex, overall capex value decreased and because of this FCF looks very much attractive. Could you please throw some light on this?

Regards

Author’s Response:

Hi,

Thanks for writing to us!

When a company invests in fixed assets, then the capex is a positive number. Similarly, when any company sells fixed assets or writes down fixed assets due to revaluation etc., then the capex will be a negative number.

You may use this logic to make interpretations and make necessary adjustments while interpreting the total capex and thereby the resultant free cash flow (FCF) in such cases.

Also read: Understanding the Annual Report Of A Company

All the best for your investing journey!

Regards

Dr. Vijay Malik

Should investors deduct dividends paid by the company from the cash flow from operations (CFO) to calculate free cash flow (FCF)?

Hi Dr Vijay,

Hope you are fine.

I have a query regarding free cash flow (FCF), which is calculated as CFO – capex. If from free cash flow we deduct dividends paid during the year, is it a better metric? Is it correct?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

The free cash flow (FCF) in the form of CFO-Capex provides the surplus cash generated by the business after meeting the capital investment requirements. One of the usages of this surplus cash is to pay dividends to the shareholders. Companies may choose to use this surplus cash for dividend payments or keep it with themselves as investments (in MF etc.) so that it may be used in future for cash requirements of the company.

We believe that CFO-Capex indicates the business characteristic of the company whereas payment of dividend indicates management decision.

With the above understanding, we believe that investors may choose to edit the ratios/parameters as per their preference.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Free Cash Flow vs Owners’ Earnings

Hello Dr Vijay,

I have gone through some blogs where I come to know about the owner’s earning and I got confused between FCF and Owner’s earning. As per your template FCF = CFO – capex where capex contains (NFA+WIP changes + DEP). Whereas Owner’s earning looks the same except capex contains only maintenance capex and not growth capex. Can we assume Maintenance capex = Depreciation and Amortization and growth capex=NFA+ WIP changes? Could you please throw some light on Both Owner’s earning and FCF? And why we are focusing on FCF in the template and not on Owner’s earning.

Regards

Author’s Response:

Hi,

Thanks for writing to me!

There are many parameters, which find relevance in investment evaluation. FCF, owner’s earnings and many other such parameters can be such examples. Every investor chooses the parameters, which she finds relevant to her in terms of understanding, availability of data, ease of computation, relevance in the industry, relevance in a particular market and many other such influencing factors.

Moreover, finance provides the freedom to the investor to tweak the formula/calculation of ratios/parameters as per her preference. E.g. ROCE may be calculated by PAT/CE or PAT/total assets or PBT/Total assets. Thereby, each ratio can be calculated and interpreted by the investors on their own.

We as investors have not delved into owners’ earnings, which other investors might have found useful. We believe that FCF calculation with a deduction of total capex serves our purpose well and therefore FCF is being used. As with incremental learning over time, we might tweak the parameters currently being used by us in future to reflect new learnings.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

There are many parameters for stock analysis and we advise that the investor should choose, which parameters serve them best and limit the analysis to selected parameters to make the stock analysis concise and meaningful as expanding the analysis beyond a particular expense hampers the decision-making.

Therefore, due to the factors mentioned above, we do not use owners’ earnings as FCF is serving the purpose well for us. However, this is not to say that other investors who find owners’ earnings useful are wrong or should not use it. It is just to state that we have not felt the need to use the owner’s earnings, therefore, it has been out of our checklist.

Read: Final Checklist for Stocks Analysis

Hope it answers your concerns.

All the best for your investing journey!

Regards

Should a company have equal FCF and CFO?

Dear Dr Malik,

Appreciate your thoughts.

I have picked from one of your articles, mentioned by you saying, “One should rely more on FCF than CFO while analyzing cash flow statement.”

As you have explained FCF = CFO – Capex, this helps us to mitigate the risk of companies trying to inflate earnings and CFO by capitalizing day-to-day operating expenses.

My understanding is to avoid the inflated earnings and CFO risk, so why do we not compare cPAT with cFCF.

Looking forward to your invaluable insight.

Kind Regards

Author’s Response:

Hi,

Thanks for writing to us!

We believe that the logic of using CFO-capex (i.e. FCF) to compare with PAT is correct in its limited context that it will provide adjustment in case management is capitalizing day-to-day operational expenses. However, as capex also includes genuine capital expenditure in plant and machinery, therefore, deducting entire capex, which might include expenditure on plant and machinery as well as capitalized operating expenditure by the management, if any, will unnecessarily penalize the company.

To have an analogy: PAT is like CTC of an employee, CFO is like take-home salary and FCF is the savings of the household after meeting the expenses. So PAT and CFO might be compared with each other but comparing PAT and FCF and expecting them to be equal may not be a prudent idea.

Further advised reading: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

How to know whether a company will be able to fund its capital expenditure (capex) from its internal accruals

Sir,

Many companies explain that their capital expenditure (Capex) would be met by internal accruals. How can an investor verify the availability of internal accruals accurately and whether it will be sufficient to meet the capital expenditure requirements?

Author’s response:

Hi,

Thanks for writing to us!

Internal accruals is primarily the money saved by the company in a year after meeting its outflows like business expenses, existing interest & debt repayments, dividends etc. Therefore, an investor may use the following formula to get an idea of the money that a company will have with itself to meet its capital expenditure (capex) requirements:

CFO – interest outflow – debt repayments – dividends (including tax) outflows

All the best for your investing journey!

Further advised reading: Understanding Cash Flow from Operations (CFO)

Regards

Dr. Vijay Malik

Are the parameters of Free Cash Flow & SSGR applicable to Banks/NBFCs as well?

Dear Vijay,

I had attended your 2nd peaceful investing workshop at Mumbai and this article was a great revision of sorts. However, could you explain how the SSGR as formulated by you and the requirement to have FCF can be used while studying financial institutions like NBFCs?

Does the concept remain the same?

Regards

Read: Finding Self Sustainable Growth Rate (SSGR): a measure of Inherent Growth Potential ofa Company

Author’s Response:

Hi,

It was great to have you at the workshop. Being from a defence background, you had brought in diversity in the workshop.

SSGR & FCF are highly relevant for companies, which have to rely on assets for generating new business. This is because SSGR relies heavily on the net fixed asset turnover (NFAT) and FCF is a result of capital expenditure (capex). For companies like financial institutions/NBFC/IT companies, which are mainly service industries and new business does not depend a lot on the amount of fixed assets, SSGR & FCF do not retain same importance.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr Vijay Malik

Can we calculate capital expenditure from the cash flow statement?

Dear Dr Malik,

It has been a pleasure reading your blogs. I have prepared my own spreadsheets for self-sustainable growth rate (SSGR) now after having read your articles.

I have a query regarding capital expenditure (capex) calculation from the cash flow statements.

Would it be fair to say that the net difference between fixed assets purchased and the proceeds from the sale of fixed assets would provide the capex for that particular year?

It would help me solve the final piece in determining the margin of safety.

Best regards,

Author’s response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

Capital expenditure (capex) for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at the start of the year and the end of the year. It can also be calculated by deducting net fixed assets & CWIP at the start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year.

Capital expenditure (capex):

(GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year

OR

(NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the year

The cash outflow under fixed assets may be thought to be a proxy of the capital expenditure for any company. However, there may be cases where there might be certain differences like:

1. E.g. if the cost of machinery in the plant is ₹100 cr. and the company paid an advance of ₹80 cr. for purchase of machinery in the previous year and showed it as a capital advance under current assets. Therefore, in the previous year, it may show it in cash flow from operations (CFO) calculation (as it is shown as current assets). In the current year, it pays only ₹20 and gets the machinery delivered. In the current year, the company may show only ₹20 as cash outflow under cash flow from investing (CFI) as the purchase of fixed assets because in the current year only ₹20 cr. has been paid for fixed assets.
2. Many times, companies may treat the cash outflow for projects under implementation differently, which are currently being shown under CWIP.

Further advised reading: Understanding Cash Flow from Operations (CFO)

As you would understand that there are many ways in which companies display their financial numbers, therefore, it is always advised to corroborate the cash flow data with the balance sheet so that we may not do any error unknowingly despite doing the hard work.

All the best for your investing journey!

Regards

Dr Vijay Malik

Similar Query: Is capital expenditure equal to cash outflow from investing activities?

Thank you! Can we consider capex as close to “Cash from Investing Activity” from the cash flow statement?

Author’s Response:

Hi

Thanks for writing to me!

Capex is not equivalent to cash from investing activities (CFI). Capex is a part of CFI and CFI includes many other elements other than capex.

Understanding The Annual Report Of A Company

Regards,

Vijay

Cash flow from operating activities (CFO) vs free cash flow (FCF)

Sir, I see at in two articles one is saying free cash flow (FCF) should positive other says that cash flow from operations (CFO) should be positive. So which point should be taken FCF or FCF? Please clear thanks because some companies have positive CFO but negative FCF.

Author’s Response:

Hi,

Thanks for writing to me!

Both CFO and FCF should be positive.

FCF is calculated as CFO – Capital Expenditure

Therefore, FCF would in most cases be positive only if CFO is positive except in cases where capital expenditure is negative meaning that instead of building new assets, the company has sold its existing assets.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr Vijay Malik

Further Advised Readings:

We recommend investors to read the following two articles to build upon their knowledge of free cash flow (FCF) to understand how we use FCF in “Peaceful Investing” approach to stock analysis:

1. Using FCF to assess Margin of Safety of any company: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing
2. Using FCF to determine the ideal PE ratio to be paid for any stock: 3 Principles to Decide the Ideal PE Ratio of a Stock for Value Investors

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.