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When following the cash can lead you astray

Free cash flow is widely used by investors – however, it is easy to make mistakes with it. While profits are sometimes treated with suspicion they can be better numbers to weigh up companies
When following the cash can lead you astray

The mantra of focusing on a company’s cash generation is not a bad one, but used in the wrong way can lead you to make mistakes.

As investors we are often told to focus on a company’s cash flows rather than its profits. Profit has built up a bad name over the years as it is seen as easier to abuse and pull the wool over people’s eyes. It is seen as more of an opinion where company directors have significant leeway to present numbers that are too rosy and may not reflect reality. Cash flows are seen as being much harder to fudge.

Many leading investors now focus on free cash flow as a way of measuring a company’s financial performance and valuing its shares. However, this is not without its own problems. 

The concept of profit is actually a very good and useful one. Accountants try to measure what is left over for shareholders after all income and expenses have been matched with each other (this principle is known as accruals) during a period of time. Cash flows as shown in a company’s cash flow statement just record the amounts of cash received and spent over the same time. This means that free cash flow in any particular year may or may not be a good representation of performance or value.

If you are going to use free cash flow as a way of measuring a company’s performance and valuing its shares, you need to be aware of its pitfalls and how it can mislead you. It can be shown that a movement in cash is not the same as a change in profit or value, whereas non-cash items can be. 

In many circumstances, some key numbers from the income statement will be more prudently stated and will be better at helping an investor determine what a company’s true profits really are, which is what they are ultimately trying to work out when looking at its accounts.

I will show you the things that you need to look out for when using free cash flow with the use of real world company examples.


What is free cash flow?

There is no universally accepted way to calculate free cash flow. As a shareholder, you are trying to work out how much cash is left over after all prior claims on the company’s cash flows have been paid. In other words, you are trying to work out the cash flow equivalent of the net income/profit number from the income statement, which is used to calculate heavily used numbers such as earnings per share (EPS).

If you were looking at US companies then free cash flow for shareholders is usually defined as operating cash flow less capital expenditure (capex). From the perspective of a UK company the free cash flow calculation can be calculated as follows:

Free cash flow = Operating cash flow less net interest paid, tax paid and capex

If a company has preferred shareholders or paid dividends to minority shareholders these payments would need to be subtracted as well.

The reasoning is that what’s left over the company is free to do with as it pleases. For example, it can pay dividends, buy back shares, make acquisitions or pay off debts.

Free cash flow is used by investors to measure company performance by calculating ratios such as free cash flow margins (free cash flow as a percentage of revenues) or seeing how much of a company’s net profits are converted into cash (free cash flow conversion). 

A free cash flow yield (free cash flow per share as a percentage of the share price) can be used to value a company’s shares and compare them with other income-producing assets such as government bonds. Free cash flow can be used as a basis for predicting future cash flows, which are used in discounted cash flow (DCF) valuation models. In short, free cash flow is seen as a very important and useful number.

The calculation of it needs to be done with great care and consideration. All the numbers you need for an initial calculation can be found in a company’s cash flow statement. 2019 and 2020 saw the presentation of cash flow statements change slightly to take into account a new accounting standard for rented or leased assets (IFRS 16).

Here is a free cash flow calculation for Next (NXT), which is very helpful for showing the slight change needed now compared with in the past.

Next: FCF calculation before and after IFRS 16

Next 2019 (£m)

Before IFRS 16

After IFRS 16

Operating Cash Flow



Tax Paid



Net operating cash flow



Purchase of property,plant & equipment (Capex)



Repayment of lease principal



Interest paid



Interest received



Free cash flow



Source: Annual Reports/Investors Chronicle

The annual lease payment, which used to be accounted for in the operating cash flow number, is now shown as a combination of interest paid and repayment of lease principal further down the cash flow statement. 

In addition to the normal deductions, you now have to subtract the lease repayment as well to calculate free cash flow. As you can see, the number is exactly the same at £494m, which is what it should be as no cash flows have changed, just the presentation of them.


Issues with free cash flow

It would be nice if we could just quickly calculate free cash flow and move on. As with many things in financial analysis and investing it is not as straightforward as that. To really gain an insight into a company and turn free cash flow into a meaningful number you need to understand the numbers behind it and use them in the right way. 

Free cash flow is subject to many influences that can mislead an investor into thinking that a company is performing better or worse than it is in reality. 

Significant distortions in a company’s annual free cash flow can be caused by the following:

  • Working capital inflows and outflows
  • Share-based payments
  • Replacement capex versus growth capex
  • Asset disposals
  • Timing differences between interest and tax expenses and cash payments

Let’s look at each of these in turn with real company examples.

Before we do. Remember, what we are trying to work out is how much money a company is making in a steady state. We need to look at the income, costs and investments that generate a company’s current profits and cash flows and strip out the costs associated with future growth.


Asos: Free cash flow and working capital cash flows

Working capital is broadly defined as the cash a company needs to fund its day-to-day activities. Money needed to pay expenses but also build stocks, give credit to customers and pay its suppliers. Changes in working capital can have a big influence on a company’s operating cash flow and therefore free cash flows and are strongly related to business growth. 

Changes in working capital cash flows contain valuable information about a company’s trading and financial position, but in most cases they are not additions or deductions to company profits or value even though they impact on free cash flow. 

The changes in working capital cash flows at fashion retailer Asos (ASC) between 2019 and 2020 are a good example of this.

Asos: FCF and working capital

Asos £m



Net operating cash flow



o/w Op profit



o/w working capital



o/w depreciation & amortisation







Net interest



Repayment of lease principal



Free cash flow



Net income



FCF conversion




Capex to depreciation



Source: Annual report/Investors Chronicle

2020 was a good year for Asos. Its profits increased significantly and so did its free cash flow compared with 2019.

Its operating profit increased by £116m, but its operating cash flow increased by £313.6m. The profit growth helped here, but the biggest increase came from £156m in working capital from a small outflow to a big inflow and higher depreciation and amortisation expenses.

Its free cash flow compared with its net income looks very impressive, but the value of the company has not increased due to working capital.

The working capital inflow largely came from an increase in creditors. The usual case for this is that a company takes longer to pay its suppliers. The cost of supplies has been expensed when calculating profit but at the year end, the company had not paid the cash. This is a timing difference and is not an increase in profit or value. A company does not become richer by not paying its bills.

A company usually has to maintain its assets by reinvesting its depreciation expense. Asos did more than this in 2019, but did so almost exactly in 2020 which helped free cash flow. I’ll have more to say on capex and depreciation shortly.

Monitoring trends in working capital cash flows is important as it can be a sign of a business’s fortunes changing, but they are generally not representative of changes in its value or profitability.


Facebook free cash flow and share-based payments

There has been a growing tendency in recent years – especially with tech companies – to pay their employees with shares or options to buy shares in the future. This is a non-cash expense, which is added back to cash flow from profit but it can represent a significant transfer in value away from the company and its existing shareholders.

This is a very complicated and debatable subject, but I am on the side of those who believe that share-based payments should be subtracted from cash flows when calculating free cash flow.

If this is done then Facebook's (US:FB) free cash flow conversion ratios show a significant change between 2017 and 2019.

Facebook: FCF and FCF conversion before and after deducting share-based payments

Year $m

Net income



FCF Conv

Adj FCF after SBP

Adj FCF conv






















Source: Annual reports/Investors Chronicle


Ashtead: A fascinating study in FCF and why owner earnings may be a better measure

One of the biggest debates in the calculation of free cash flow is whether to deduct all capex spending or stay-in-business or maintenance capex. By including just maintenance capex it means that companies that are investing for growth are not penalised on the FCF measure by having lower or negative free cash flows. Using maintenance capex also gives a more accurate and realistic view of a company’s ability to turn profits into cash.

However, there is also an argument for including all capex. This is because sometimes companies underdepreciate their assets and flatter their profits. The higher cash spent to maintain assets is picked up in the capex number in the cash flow statement. As with all financial analysis it should be done over a period of time rather than just one year in order to take anything useful from it.

The problem that outside investors have is working out what maintenance capex is. Most companies don’t tell you the number. Depreciation which reduces profits is a rough proxy for maintenance capex, but has the problem of being backwards-looking and being based on historic rather than current costs. However, it is often the best figure an investor will have to work with.

Equipment hire specialist Ashtead (AHT) is one of the few companies that does tell investors what it has spent on maintenance or replacement capex. It also throws up some very interesting analysis points on the differences between interest and tax expenses and cash paid for them.

If we start off with a basic calculation of Ashtead’s free cash flow in 2020, we can deal with these important issues in turn.

(Note that Ashtead’s operating cash flow number of £2430m excludes the profits made on rental equipment sales.)

Ashtead: FCF calculation 2020

Operating cash flow




Rental capex


Non-rental capex


Lease repayments


Financing costs


Tax paid


Rental disposals


Free cash flow


Adj net income


Free cash conversion


Source: Annual report/Investors’ Chronicle

At first glance, the company’s FCF generation looks pretty good and is close to its reported adjusted net income – the number that many investors pay close attention to.

Note that I have included cash received from asset disposals in the calculation. In my opinion, this is fine when disposals are a regular and ongoing part of a business. This is true with rental equipment, but would also apply to businesses such as pubs and property companies. Be careful to check that the operating cash flow number does not include profits from asset disposals (Ashtead’s does not) as there will be an element of double counting by including cash inflows from disposals as well.

If we then adjust free cash flow to just deduct rental replacement capex then Ashtead’s free cash generation looks even better.

Ashtead: Adjusted FCF 2020 (£m)

Operating cash flow




Replacement rental capex


Non-rental capex


Lease repayments


Ongoing financing costs


Tax paid




Rental disposals


Adjusted free cash flow


Adj net income


FCF conv


Source: Annual report/Investors’ Chronicle

The easy conclusion to make when looking at numbers like this is that you have come across a business that is massively understating its profits. It is possible that it could be, but you should do three crucial comparative checks to try to understand why the cash conversion is so good:

  • Compare rental replacement capex with rental depreciation.
  • Compare interest expensed in the income statement with cash interest paid.
  • Compare the tax expense in the income statement with cash tax paid.
Ashtead: Rental capex vs rental depreciation

Year £m

Rental depreciation

Rental replacement


























Source: Annual Report/Investors Chronicle

We can see that Ashtead has generally spent less on replacement capex than its rental depreciation expense in recent years. It could be that it is overdepreciating, but a more likely cause is that replacement capex only applies to a proportion of total assets whereas depreciation is the expense on all assets. Replacement capex will be lumpy and depend on the growth of the rental fleet in previous years. 

In this case, I’d be more inclined to use depreciation as a measure of maintenance capex than the cash actually spent if I want a prudent measure of cash flows and profits.

Ashtead: Tax expense vs tax paid

Year £m

Income Taxation Exp

Cash tax paid


























Source: Annual Reports/Investors Chronicle

By doing this comparison, I find a major reason why Ashtead’s free cash generation looks so good compared with its profits. It has been paying a lot less in cash taxes than it has been expensing against its profits.

When you come across a situation like this you should go to the financial review section of the company’s annual report to see if there is an explanation. The reason for the big difference is that Ashtead’s rental assets qualify for accelerated tax depreciation. 

This means that its taxable profits and tax bill from newer rental assets are lower in their early life than they are later on compared with accounting profits. This gives Ashtead a low cash tax bill, but it has to account for the timing difference when taxes rise later on by expensing something called deferred tax in its income statement.

Ashtead has a deferred tax liability for accelerated depreciation on its balance sheet which has increased significantly in recent years. If the company keeps spending heavily on new assets then it can keep its cash tax bill low for a good while yet, but if spending comes down – as it will eventually as the business matures – then Ashtead’s cash tax bill would increase significantly. Its much higher tax expense in its income statement reflects this and is arguably a much better number to base a profit calculation on than the number in the cash flow statement.


Ashtead: Interest expense vs interest paid

Year £m

Income Interest expense

Cash Interest paid


























Source:Annual report/Investors’ Chronicle

These two figures are not too far apart. The difference in 2020 can largely be explained by timing issues and some non-cash interest. The annual cash interest expense on borrowings and leases in 2020 was £217.1m.


Applying Warren Buffett’s concept of owner earnings to Ashtead

Warren Buffett works out a company’s owner earnings based on stay-in-business capex, working capital and other adjustments. I have included rental depreciation as a proxy for stay-in-business capex and used the income statement tax expense and annual cash interest expense.

This gives the owner earnings estimate of £956.4m which, compares favourably with adjusted net income largely due to including cash inflows from asset sales. If these were excluded and the profit from sales of £33m was included instead the estimate would change to around £740m.

Ashtead: Owner earnings estimate 2020 (£m)

Operating cash flow before changes in rental equipment




Rental depreciation


Non-rental capex


Lease Repayments


Ongoing Financing costs


Tax Expense


Rental disposals


Working capital adj


Owner Earnings



Adj Net income


FCF Conv


Source: Annual report/Investors’ Chronicle

What I have concluded from this analysis is that Ashtead’s net income looks a pretty solid number to me and is a better measure to base its financial performance and valuation on than free cash flow.

This won’t always be the case for every company, but the process of checking allows the investor to learn a great deal about the company and its business in the meantime, which is no bad thing.