Cash Flow Analysis

[galumay]

I am slowly educating myself a little more about cash flow, its quite a complicated subject I am finding!

I have picked up the basic formula for free cash flow calculated by taking operating cash flow and subtracting capital expenditures.

I am unsure exactly which items I should regard as capital expenditiure, for example are aquisitions and investments in joint ventures capital expences?

Another problem I am finding is understanding how to treat things like share issues, proceeds from borrowings and bond issues in the cash flows from financing activities. These can make the cash flow look great!

Does anyone have a good book or paper they would recommend to help me learn to quickly read and understand the statement of cash flow in an annual report?

 

[luutzu]

I am slowly educating myself a little more about cash flow, its quite a complicated subject I am finding!

I have picked up the basic formula for free cash flow calculated by taking operating cash flow and subtracting capital expenditures.

I am unsure exactly which items I should regard as capital expenditiure, for example are aquisitions and investments in joint ventures capital expences?

Another problem I am finding is understanding how to treat things like share issues, proceeds from borrowings and bond issues in the cash flows from financing activities. These can make the cash flow look great!

Does anyone have a good book or paper they would recommend to help me learn to quickly read and understand the statement of cash flow in an annual report?

FCF = EBIT - taxes + depreciation - change in net working capital - capital expenditures

capex should be the expenses necessary to maintain operations - parts or depreciation to replace plants/equipment. Acquisition and Investments is not capex.


I guess it depends, but you wouldn't want a company that borrow too much, either through issuing new shares or through debts.

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What I do is break cash flows down into the three main activities: operating, investing, financing.

Then get the net of each. Do this before any ratio calculation.

In general, you'd want a positive operating cash flow; negative the other two.
So an overall negative CF might not be a bad thing, could mean large investments are made, or large dividends etc., But a negative flow from operation but high financing income (borrowing) or positive investment CF (say they sold their investments instead of making new (outflow) investments.

So it depends on the business. Just a formula alone could be misleading.

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Any Investments textbook should cover this pretty well, no need for accounting text.

 

[skc]

I am slowly educating myself a little more about cash flow, its quite a complicated subject I am finding!

I think it's better to pick a company and discuss around that.

I suggest you taking a look at NUF's H1 and Full year results (out last week) and focus on the cashflow.

It will explain a lot.

 

[galumay]

Thanks luutzu & skc, I will follow up and look into NUF's results - I had been doing that with a couple of other companies and thats what got me started! (IMF & SGH).

I am out bush & offline for a few days but will follow up when i get a chance.

 

[VSntchr]

FCF = EBIT - taxes + depreciation - change in net working capital - capital expenditures

capex should be the expenses necessary to maintain operations - parts or depreciation to replace plants/equipment. Acquisition and Investments is not capex.

It's really good to get some discussion on this topic. Some good posts already.

One question with your formula above - I see that you are dealing with spending on physical assets by backing out depreciation and adding back capital expenditure, but what about R&D which results in intangible assets such as software? Amortisation is on assets such as these is a real expenditure IMO as it has to be replaced as it becomes out-of-date etc.

Also, with regard to acquisitions - I agree that they are not capex - but when companies become serial, or even semi-serial, acquirers I think that this level of "investment" needs to be considered in a cash flow analysis.

 

[skc]

Thanks luutzu & skc, I will follow up and look into NUF's results - I had been doing that with a couple of other companies and thats what got me started! (IMF & SGH).

I am out bush & offline for a few days but will follow up when i get a chance.

Don't start with IMF. It is famous for lumpy cashflow (due to the nature of its long-dated big cases) and it's highly unusual (albeit simple once you understand) set of accounts. Come back to it later, however, as it will reinforce your understanding.

Enjoy the bush and life offline!

 

[galumay]

Enjoy the bush and life offline!

Thanks! Ok, I am back on board, very relaxing week in the end, lots of mud crabs and oysters off the rocks!

I had a look at NUF and my first question would be about the capital expenditure in the investing cash flows, the plant & equipment at $44.460m is obvious, but what about the "Product Development Expenditure"? Would you consider that capital in nature - it would obviously have a big impact on any FCF calculation if included.

My understanding is that FCF = Net Operating Cash Flow - Capital Expenditure. ( wondering why financing cash flow doesnt play a part in the calculation).

Using capital expenditure of $44.46m i get a FCF of 84.7c per share and if I use the formula suggested in the Buffet thread, IV=E/r then I get a very high IV for NUF - so I have either missed something really obvious - or I should place a buy order!

 

[galumay]

Further to those questions, just reading my annual report for CDA and a similar entry of "Payments for Capitilised product Development" appears - same question, is that capital expenditure for the purpose of calculating free cash flow?

 

[skc]

My understanding is that FCF = Net Operating Cash Flow - Capital Expenditure.

I had a look at NUF and my first question would be about the capital expenditure in the investing cash flows, the plant & equipment at $44.460m is obvious, but what about the "Product Development Expenditure"? Would you consider that capital in nature - it would obviously have a big impact on any FCF calculation if included.

What's the point of calculating FCF? As the name implies, free cash flow is cash flow which the owner is "free" to do anything with. They can pay dividends, return capital, retire debt or invest in new business opportunities.

So FCF = Net operating cash flow minus non-discretionary capital expenditure (or sustaining capital often used in mining companies).

Deciding whether a capital expenditure cashflow is discretionary or sustaining can be difficult at times, and there are often grey areas. In general, something that earns you new additional income is most likely discretionary, something you spend to make sure you keep earning your existing income is non-discretionary.

One way to decide is to look back at a few years and see if the same item keep popping up. For NUF, the product development expenditure from 2011 to 2014 $37.4m, $34.3m, $51,9m and $59.7m. So it looks pretty much like it is non-discretionary. If you look across the revenue line, from 2011 to 2014, it went from $2.27B to $2.16B to $2.46B to $2.7B. So it's difficult to assess if the product development expenditures have resulted in higher sales. In this case, I'd be conservative and say the full amount of this item is non-discretionary in nature. In fact, if I was the CFO I would just expense it and get a better tax deduction.

Using capital expenditure of $44.46m i get a FCF of 84.7c per share and if I use the formula suggested in the Buffet thread, IV=E/r then I get a very high IV for NUF - so I have either missed something really obvious - or I should place a buy order!

Again, you need to look across several periods to see if the cashflow is consistent over the periods. A business can have 1 or 2 periods of very strong cashflow by playing with working capital (collect receivables more and earlier, paying payables less later, reducing inventory etc). Sometimes it's a permanent reduction in working capital, other times it's just kicking the can down the road and massaging the results.

NUF over the years is probably doing FCF of $90-120m over the last 5 years, without too much trend in one direction or another. So that's what my reference point would be until some consistent change is evident/probable.

If you have time take a look at the dramatic change in operating cashflow between half year and full year for NUF, and analyse where the differences arise from. And for a trader, see how the market reacted to the reported figures.

( wondering why financing cash flow doesnt play a part in the calculation).

Because financing cashflow is a function of how the business is financed. It has little impact on the actual operation of the business. If I am buying a business, the FCF is what it is (with due adjustment to the interest payment), regardless of whether I am buying it with 100% equity or 90/10 debt/equity.

Financing cashflow decisions are the result of FCF. i.e. whether they pay a dividend, repay debt or need to borrow more to invest/operate.

Thanks! Ok, I am back on board, very relaxing week in the end, lots of mud crabs and oysters off the rocks!

 

[galumay]

Thanks SKC, i really appreciate you taking the time to help me understand better. I will look into the points you raise in more detail, the non-discretionary spending makes sense to me too.

I guess part of the journey is just reading all the annual reports as they roll in and growing my understanding over time - just looking at CCP now and its tricky! The purchase of PDL's results in a negative net cash flow from operating activities - which throws all my comparisons out the window!

 

[McLovin]

What's the point of calculating FCF? As the name implies, free cash flow is cash flow which the owner is "free" to do anything with. They can pay dividends, return capital, retire debt or invest in new business opportunities.

So FCF = Net operating cash flow minus non-discretionary capital expenditure (or sustaining capital often used in mining companies).

The only issue with that method is that it removes discretionary capex but doesn't remove discretionary increase in wc. And of course if you're building a model that assumes growth, that growth needs to be paid for somehow which reduces the amount available to be paid out. I've made that mistake myself plenty of times; assuming that growth is free.

 

[galumay]

I've made that mistake myself plenty of times; assuming that growth is free.

Interesting point, so how best to allow for the cost of growth within FCF calculation? Do you just apply a flat %?

 

[McLovin]

Interesting point, so how best to allow for the cost of growth within FCF calculation? Do you just apply a flat %?

You can get some idea of growth potential and cost from ROIC. For example, at 30% ROIC, retaining 50% will grow earnings at 15%. That'll give you some ballpark number of what each incremental $ invested will generate. Remember that if the firm is levered then you need to adjust for that in the fcf. Sorry, it starts to get a bit like a bowl of spaghetti.

Have a look here http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/cashflows.pdf

It might help.

Once you get your head around fcf (I don't think you ever master it because it's very much an art) you get a pretty good insight into why NVT business model is so wonderful.

 

[galumay]

Sorry, it starts to get a bit like a bowl of spaghetti.

I am starting to see that!! Everything is interrelated isnt it?! Oh, well its all part of the learning curve and I will have a whole year while on our 'gap' year to study and learn.

One interesting thing is that so far all the companies I have checked that I have invested in, both in my investment portfolio and our SMSF, have looked ok now that I look back in hindsight at their cash flow statements.

 

[VSntchr]

Once you get your head around fcf (I don't think you ever master it because it's very much an art) you get a pretty good insight into why NVT business model is so wonderful.

Reading your first post in this thread instantly brought NVT to mind. Missing the "cost" of growth here might have resulted in an under-valuation!


As for forgetting about the cost of growth, a perfect example is when you see the army of rampers on HC talking about valuations for stocks like AHZ (and similar) in the $1.00+ range. It's easy to use a valuation model to project out big increases in revenue and margin expansion - but this comes at a cost.

The costs involve, as McLovin pointed out, working capital expansion - you will need to hold more inventory etc.
PPE - you will need more infrastructure to support your business in the form of manafacturing/warehouse/distribution lines.
Intangibles - these may be developed internally, or acquired. Either way, they are a real cost of the business and need to be accounted for. For example, as the business grows you will need to employ a better software system that ensures all proper inventory/workforce/scheduling management.

These are just a few off the top of my head that are relevant considerations with regard to the costs of growth, a good area to explore within the Cash Flow realm that McLovin has highlighted.

This area is looking more into the forecasting of FCF, looking at past FCF is the best place to start learning -remembering that the end-goal is to be able to get a thorough enough understanding of each business and the way cash moves around so that you can have decent guestimations at what is going to happen in following periods.

 

[luutzu]

You can get some idea of growth potential and cost from ROIC. For example, at 30% ROIC, retaining 50% will grow earnings at 15%. That'll give you some ballpark number of what each incremental $ invested will generate. Remember that if the firm is levered then you need to adjust for that in the fcf. Sorry, it starts to get a bit like a bowl of spaghetti.

Have a look here http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/cashflows.pdf

It might help.

Once you get your head around fcf (I don't think you ever master it because it's very much an art) you get a pretty good insight into why NVT business model is so wonderful.

hi McLovin,

With that limit of growth formula, or growth potential, sustainable growth... I've come across it before, from various sources... although they use the ROE instead of ROIC - same thing I guess;

So a company's growth potential = ROE x % of retained earnings....

Issue I have is from the examples they showed, it doesn't work out that way.. and from my own thinking, which isn't worth much, but I don't see it working like that either.

From what I understand and how I define growth... It's growth in profit, as measured by ROE - how much profit can the equity holder get, or how much return is from invested capital....

So if my business had generally returned me 15% on equity... and assuming I only return capital to myself as dividends and retained back earnings I think I can grow at historical level (if I can return higher, I'd probably retain more so it's around the historical level of return)... So why does my growth potential be limited, or be defined, by how much I retain or pay out?

So this formula only make sense if we define growth as the size of the equity, and not the growth in terms of profitability. I didn't go further into by how large the equity would grow and its relation with retained earning to see if that's what is meant... but in terms of growth potential as defined by ROE/ROIC... if retaining more earnings wouldn't really affect its growth in profitability, just its size... and for an investor, as opposed to the executive whose paid depends on the size of his kingdom... profitability is what we're interested in when we talk of growth - because it is our money and we grow it by profit on it.

see table below from a textbook I read before.

ROE and Sustainable growth rate don't match - seems the company can grow its ROE quite sustainably higher than the potential growth as predicted by the g = ROE x %retained.

 

[luutzu]

It's really good to get some discussion on this topic. Some good posts already.

One question with your formula above - I see that you are dealing with spending on physical assets by backing out depreciation and adding back capital expenditure, but what about R&D which results in intangible assets such as software? Amortisation is on assets such as these is a real expenditure IMO as it has to be replaced as it becomes out-of-date etc.

Also, with regard to acquisitions - I agree that they are not capex - but when companies become serial, or even semi-serial, acquirers I think that this level of "investment" needs to be considered in a cash flow analysis.

There's a reason I automate these stuff, so no need to think, haha.

The capex and depreciation was, from memory, so I could get the net capex out. I made assumption that if a company does sell as well as buy its PPE.

With software... no idea. I generally consider softwares and ERP systems to be costs of operation, not investment. Unless the business make and sell softwares.
It's tough and I never really thought hard about it but I prefer management to be conservative in claiming R&D... I mean, you can claim advertising and promotion as marketing R&D but maybe it ought to be part of normal operation; same with developing or buying software to make your business more efficient.

With serial acquirers... to me, a business ought to only invest and acquire new business from current profits... not necessarily entirely from profit, but its operating cash flow ought to be profitable. Doesn't make sense to keep acquiring new businesses when you can hardly run the existing ones.

So a normal business that's losing money but spend too much in its "investing" cash outflows, mostly funded from incoming financing activities... i stay away from. A good example is Transpacific. Kept losing money but expand like crazy, it didn't end well.


What's investing to one business is just normal operation for another. Say land... for a general industrial company... it buying a block of land next to its shops or nearby because it's cheap and such, that's an investment; for a developer, if it's part of its landbank and to be developed and sold, is that purchase part of its normal operation or an investment? I'd put that as normal operation it might not realised profit/loss until a couple years later.

 

[galumay]

Once you get your head around fcf (I don't think you ever master it because it's very much an art) you get a pretty good insight into why NVT business model is so wonderful.

I feel a bit like I am sinking here!! (especially when i add Luutzu's comments and analysis to my education!)

I have studied NVT's cash flow and I have to admit I am struggling to pick up the key to the success of the business model. I hold NVT too, so I have a particular interest in understanding its special advantage and I was hoping that i would have an epiphany and get it, but i havent been able to piece together the parts to see the story of the whole.

 

[McLovin]

see table below from a textbook I read before.

ROE and Sustainable growth rate don't match - seems the company can grow its ROE quite sustainably higher than the potential growth as predicted by the g = ROE x %retained.

View attachment 59718

I'm a little confused by your post, but the table you've provided does show the point I was making...

retained earnings * RoE (ROIC is superior) = sustainable growth rate.

In 1982: 72% * 18.73% = 13.49%

I think you're confusing growth rate with RoE. Of course if incremental ROE (ROIC) is higher than historical ROIC then you'll get a theoretical growth rate that is higher than what the balance sheet would suggest.

Also, in terms of FCF this won't work in the case of NVT because it won't capture the fact they can grow while paying out everything.

 

[McLovin]

I have studied NVT's cash flow and I have to admit I am struggling to pick up the key to the success of the business model. I hold NVT too, so I have a particular interest in understanding its special advantage and I was hoping that i would have an epiphany and get it, but i havent been able to piece together the parts to see the story of the whole.

Check out the operating leverage (working capital), especially deferred revenue. They use their students' money (at no cost) to fund the business.