How do you know if a company’s spending the right amount?

Companies that generate lots of free cashflow can be good investments. It means there’s more money to spend on things like dividends, or new assets to propel growth.

But it’s important to understand how to spot if good free cashflow is sustainable. This is especially important now.

Lots of businesses supported cash generation by slashing spending in the pandemic. This made sense, considering the unprecedented disruption to demand. But if it becomes a longer-term pattern, it could stifle future growth. If a company continually under-invests in itself, it might have to spend a lot in the future, or be unable to continue serving its customers well.

Why care about cash?

Here on the share research team, we beat the same drum a lot. That drum is “cash is king”.

Cash is different to earnings. It’s the amount of cash physically flowing through the business, after everything – from salaries to new computers, and the tax bill – is paid for.

Cash is very hard to manipulate, unlike revenue and profit numbers. So free cashflow, or the amount of cash a company generates, should be looked at carefully before deciding whether to invest.

For the shares that we follow we look at things like free cashflow and a company’s longer-term prospects in our share research. We cover over 100 of the UK’s largest listed companies, and research can be emailed to you for free if you sign up to our alert service, to help you make your own investment decisions.

Sign up to our share research

How do I do it?

Free cashflow is calculated as the net amount of cash generated from operations, minus the amount spent on capital expenditure (capex). Capex can sometimes appear as “property, plant and equipment” on the cashflow statement.

Capex is money spent on maintaining, upgrading or buying assets. It could be fixing leaky taps in the breakroom, upgrading the IT system, or building a new factory. All in, capex is crucial for maintaining a business, as well as funding growth.

Cashflow statements can look a little dense, but once you know what numbers you’re looking for, working out free cashflow isn’t much work. The example below is a snippet of what you can expect to find on a traditional statement. We can see the company generated £45m in free cashflow this year, once you work out the total spent on property, plant and equipment .

Why does it matter now?

During the pandemic, lots of companies slashed capex in order to help preserve cash. In such extreme and uncertain times, this move made sense.

But some used language like “strong” cashflow generation. We think that’s a bit of a stretch when it’s only been achieved by sewing the purse strings shut, rather than a result of improving net cash from operations.

As we start to emerge from lockdowns, companies will be keen to demonstrate financial resilience – including strong free cashflow generation.

If it continues to come from reduced capital expenditure, that doesn’t bode well for future growth prospects and could signal a company’s actually struggling.

What does under-investing look like?

Some companies have higher capex requirements than others. A brewery for example is likely to need more capital expenditure than an asset-light technology company.

So, one of the best ways to work out if a company is spending too little is to compare its capital expenditure as a proportion of sales over time.

You’ll need to look back at the last five years as a minimum (pre-pandemic) to get a good idea of what’s normal. This is a quick way to sense-check if spending levels are returning to where they should be, as we start to get post-pandemic results in the coming months.

Another option is a little more in-depth, but isn’t as hard as it sounds.

Is spending keeping up with degradation of assets?

Like we’ve said, assets need maintaining if they’re to be effective. In the same vein, assets lose value, or depreciate, every year. When this happens for physical assets, like equipment, a company will recognise a depreciation charge. When it happens for non-physical assets, like a brand or intellectual property, it’s called amortisation.

If capital expenditure exceeds the depreciation and amortisation charges, then it’s a sign enough is being spent to maintain assets. It means the amount being spent to maintain or upgrade assets at least matches the speed at which they’re deteriorating.

Can a company spend too much?

Yes. But it’s about looking for a pattern.

If a company is expanding – building new warehouses or acquiring businesses for growth, capex is likely to be higher. This is reasonable, and standard practice. The important thing to watch out for, is if capex spikes ahead of expectations. Management will usually talk about capex guidance – especially if it’s set to rise – in the annual report, or full year results.

It’s also important to notice if a company consistently ups its capital expenditure budget. If management says it’s spending £500m over five years, but this keeps getting bumped upwards, it can suggest a loose grip on spending. More troubling is when this implies the company simply has higher ongoing capex needs than originally thought.

By looking at the capex/sales ratio as before, you should be able to get a feel for what exceptional spending looks like. Keep in mind that if it looks like a business is really pushing itself financially, it increases execution risk. If things don’t go to plan, it can mean dividends are on the chopping block, among other unwanted surprises.

What to remember

Just because a company reports well controlled free cashflow, doesn’t mean all is well.

It’s crucial a company invests the right amount in its upkeep, if it wants to prosper. This is especially crucial now.

Companies that dropped capex during the pandemic will want to continue to report strong free cashflow generation, and this could come from a prolonged cap on spending.

This article is not personal advice. If you're not sure if an investment is right for you, please speak to a financial adviser. All investments rise and fall in value, so you could get back less than you invest.

---

Share insight: our weekly email

Sign up to receive weekly shares content from HL