Cash flow – what is it and why does it matter?

Cash flow sounds like a dry subject. But it really matters, and it matters now more than ever. It’s also not as hard to wrap your head around as you might think.

A trend we’re seeing now is that for some companies, profits are improving, but cash flow isn’t enjoying the same boost. That’s largely because they aren’t facing the same impairment or provision charges (more on that later) as they did in the onset of the pandemic.

Cash flow can often be a much better indicator of financial health than profit. All sorts of things can affect profit, and it’s a more easily manipulated number. You can’t really do that with cash.

Why is profit different to cash?

Cash flow represents the amount of actual cash entering and leaving the business. It shows what’s left over from running operations that can then be used for other purposes like to pay down debts or pay a dividend.

An easy example would be depreciation. If a company spends £5m on some new machinery in a year, it rarely shows up as a £5m deduction on the income statement. Instead it’s often reflected in an annual depreciation charge to reflect the degrading value of the machine over its life. For example, £500,000 a year. That will affect profit, but not cash. The cash impact is a one off – £5m to reflect how much money actually left the business to pay for the equipment.

Another common one is impairment charges. These are when a company reassesses the value of its assets downwards. We saw a lot of this during the pandemic, where the huge disruption meant projections of future profits from assets were lowered, which damaged what those assets were worth. For example, Frasers Group, which owns Sports Direct, had impairment charges of £317m last year, which meant operating profits swung dramatically from a £172m profit, to a £60m loss. These write-downs aren’t actually cash leaving the business though, so it didn’t affect the cash flow statement.

Mind the gap

There are two main types of cash flow – cash flow from operations and free cash flow.

Cash flow from operations, which might appear as ‘cash flow from operating activities’, is the first line on the cash flow statement that needs attention.

To get to this figure you need to amend for all the non-cash movements that affected operating profit. Since operating profits are calculated before interest and tax, you also need to deduct these and then add back any earned interest on the cash deposits.

This example table below demonstrates the process.

The other important figure is free cash flow. This takes the operating cash flow but accounts for money spent on property, plant and equipment (capital expenditure). So, things like new warehouses or machinery.

This investment will usually appear in the ‘cash flows from investing activities’ section. It’s as simple as deducting the capital expenditure away from operating cash flow. Some companies will give you the free cash flow figure themselves, but if you need to calculate it yourself – now you know how.

What does free cash flow teach me?

Not only does it show you how a company’s finances really look, it can give investors an idea of dividends. A company that generates healthy levels of free cash flow will, in theory, be able to sustain, or even increase how much they return to shareholders. A key measure of dividend sustainability – although this is by no means the only thing to consider – is how well a dividend is covered by free cash flow.

To work this out, all you need to do is divide free cash flow by dividends paid. Anything around or over one would be deemed as a healthy cover in our view.

Anything less than this could, but wouldn’t definitely mean, a company might face some difficulty growing, or in severe cases, sustaining the dividend. Remember, yields are variable and no dividend is ever guaranteed. They are not a reliable indicator of future income.

Free cash flow yield

Free cash flow is also used for working out the free cash flow yield. This compares the amount of free cash flow a company is expected to generate, against the share price.

Free cash flow yield = Free cash flow per share / share price

A higher free cash flow yield is favourable. It shows a company is more likely to generate more cash, which can be used to pay debt or dividends. One way to think of a higher free cash flow yield, is that a higher proportion of each pound you invest will get turned into cash, rather than frittered away.

So, falling cash flow is bad?

Not always. If a company is expanding for example, they’ll tend to use their available cash before turning to external financing. So, if building more infrastructure is part of a strategy shift, and there’s an associated increase in capital expenditure, and free cash flow falls, this isn’t necessarily something to worry about.

It’s more important to look out for unexplained or unexpected spikes in capital expenditure, or if cash flow is continuously falling despite a sustained increase in profits.

A key thing to look out for is payables and receivables. If payables (money owed to others) are getting bigger, this is actually – somewhat counterintuitively – a good thing. It means there are more favourable payment terms. If payables shrink, it can mean suppliers are demanding money more quickly. If receivables are getting bigger – so the amount of money owed to the business is growing – this can also be bad. It means the company is being paid by others more slowly.

What do I do with this information?

The pandemic has highlighted the difference between profit and cash in a way we’ve not seen for a long while. Understanding cash flow, and knowing how to apply it, lets you truly see what condition a company’s finances are in.

We understand not everyone will want to plough through company financial statements – although we think it’s important investors understand the basics.

This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Ratios and measures shouldn’t be looked at in isolation, you should look at the bigger pictures. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

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