To be a better investor, follow the cash

A company’s cash flow statement is arguably the most valuable bit of information contained in its annual report. It can help you identify excellent businesses and keep you away from bad ones. This article is all about showing you how to use the numbers found in a company’s cash flow statement and turn them into very useful information. 

The cash flow statement 

Cash flow statements are broken down into three main sections: 

• Net cash flows from operating activities – the cash generated or used from a company selling its goods or services. 
• Net cash used in investing activities – includes cash used to buy new assets and companies. Cash raised from selling assets and businesses. 
• Net cash used in financing activities – includes cash used to pay interest, dividends, repay loans or repurchase shares. Cash received from interest income, new loans or new share issues. 

These three sections are added together to show the change in a company’s cash balance (shown on its balance sheet) during a period of time – usually a year or six months. 

Below is the cash flow statement of premium soft drinks company Fevertree (FEVR). I am going to use it to show you what you can do with the numbers in it – and a few numbers commonly found elsewhere on income statements and balance sheets – to learn more about the business. 

Cash flow analysis can be used by investors to check out the following: 

• Whether a company’s profits are believable or not – do profits convert into cash? 
• How much – or how little – a company is investing in its business. 
• The safety of its dividend payments – does it have enough spare cash to pay them? 
• How good its financial performance is – is it making good returns for investors? 
• A company’s sources and uses of cash. 
• How cheap or expensive its shares are – its free cash flow yield.

Free cash flow 

Before we start digging a little deeper into Fevertree’s cash flow, I am going to explain something called free cash flow, which is used extensively by investors when weighing up a company. 

Free cash flow is the amount of money a company has left over after it has paid all its non-discretionary bills – money it can’t avoid spending – and is free to do with it whatever it wants. The money can be used to pay dividends, repay debts, invest in the business, make acquisitions or buy back shares.  

Free cash flow is often cited as the true source of a company’s value. The most valuable companies tend to produce lots of free cash flow and keep growing it. 

There is no universally accepted definition of free cash flow or how to calculate it. If I am looking at the free cash flows that go to shareholders, I start with the company’s net cash flow from operating activities, add any dividends from joint venture companies and then take away net interest paid (interest received less interest paid) and money spent on new assets (capex). Unless selling assets (like pubs or property companies) is a regular part of a business, I ignore cash inflows from asset disposals. 

Fevertree’s free cash flow is shown below. As with any calculation it is always better to look at a trend rather than one year in isolation. As you can see, Fevertree has gone from a business that wasn’t producing any free cash flow to one that has been generating a growing amount of it. 

One of the reasons for Fevertree’s free cash flow is that it does not make or distribute its products. These are outsourced to third parties. This means that the investment requirements of the business in manufacturing and distribution assets are nothing. 

Free cash flow is generally seen as a good thing. However, one of the problems with it is that companies that invest money in new assets in order to grow often have very weak or negative free cash flows. Does this make them bad businesses? 

Certainly not if the money spent is earning a good return. The underlying free cash flow of the business can be very good, but is masked by heavy investments in new assets.  

Ideally, a company will tell you how much money it spends on capex to replace existing assets (known as maintenance or stay in business capex) and how much is spent on expanding the size of the company. Unfortunately, not many do so. The depreciation expense is often a reasonable starting proxy for maintenance capex, but can’t always be relied upon. 

Pub company JD Wetherspoon (JDW) does tell investors how it spends its money on new assets. This allows the investor to understand the business better. Its free cash performance looks poor due to it buying freehold properties in recent years, but actually it’s not too bad at all. 

Using cash flows to check the quality of company profits 

Over time, good businesses turn the bulk of their profits into cash flow. Bad ones don't. There are three main checks of profit quality using cash flow: 

1. Comparing operating profits with operating cash flow. If operating cash flows are consistently less than 90 per cent of operating profits you might want to try to find out why. Sometimes this can be a sign that profits are being manipulated. 
2. Comparing Ebitda with operating cash flow. Depreciation is a source of operating cash flow as it a non-cash expense that reduces profits and can be significant. This means that comparing operating cash flow with operating profits for companies with big depreciation expenses is quite an easy test to pass. Comparing it with Ebitda (earnings before interest, tax, depreciation and amortisation) is a bigger hurdle to cross. 
3. Comparing free cash flows with post tax profits. Free cash flows can be less than profits if a business is investing heavily. The same is also true if a company is fudging its profits by capitalising costs (sticking them on the balance sheet instead of expensing them in the income statement). As a general rule, I like to see free cash flow equate to at least 80 per cent of profits over a five-year period, but don’t want to discriminate against good businesses investing money in profitable projects. 

Let’s see how Fevertree measures up against these tests. 

Not great seems to be the answer. Its operating and free cash flows are significantly lower than its profits. 

So what is going on here? Are investors to think that Fevertree’s profits are not as high as it says they are? 

Going back and looking at the cash flow statement, the reason for Fevertree’s poor cash conversion is due to significant cash outflows from working capital – mainly an increase in receivables; invoices unpaid at the end of the year. These receivables represent sales – and the profits from them – that have been booked in the income statement but where the cash has not been received from customers. 

Fevertree is a very fast-growing business where it is quite normal to offer customers credit terms in order to grow sales. The question is whether the company is becoming too reliant on credit in order to grow and meet the expectations of investors.  

The company is clearly not overtrading – this is when the increases in sales are too fast and put a strain on the company’s finances – but the growth in receivables has been growing faster than sales and now accounts for nearly a third of sales, which is higher than other quoted soft drinks companies (Vimto owner Nichols is the next highest with receivables at 26 per cent of sales). 

As long as these receivables turn into cash – and bad debts are not a problem for Fevertree – there is no reason to question Fevertree’s profits in my opinion. That said, for me, it is something that needs watching as extending credit can only go so far in driving a company’s sales growth. 

How much is a company investing? 

Most companies need to invest in their assets in order to keep their business running smoothly. There are two checks on how much or how little a company is investing that can be worked out from a cash flow statement. 

The first one is comparing capex with depreciation. Investing less than depreciation for a period of time can be a sign of underinvestment in a business that will eventually damage its sales and profits. In rarer cases, it can also be a sign of very prudent depreciation policies – and conservatively stated profits. 

Fevertree’s investment levels are about in line with its depreciation expense. Given its low investment needs, this is nothing to worry about. 

The other measure of investment rate is looking at capex as a percentage of operating cash flow – how much money is reinvested as a percentage of the cash generated from trading. Fevertree has a very low investment rate. 

One of the reasons why Fevertree has been such a good investment in recent years is because it hasn’t needed to spend a lot of money on new assets in order to grow. Looking for growing companies with low ongoing investment requirements can be a happy hunting ground for investors. 

A check on dividend safety 

The biggest reason for a dividend to be cut is a lack of free cash flow to pay it. A very quick and powerful test of dividend safety is comparing a company’s free cash flow with the cost of its annual dividend – known as free cash flow dividend cover. Cover of less than one for a prolonged period of time could be a sign of a company borrowing to pay its dividend, which can’t go on indefinitely. 

Fevertree’s current dividend looks very safe and has scope to grow 

If you come across a share with a very high dividend yield (say more than 6 per cent) it might be a good idea to check out the free cash dividend cover. High yields usually occur because there are lots of doubts as to whether the dividend can be maintained. If there isn’t enough free cash flow to pay it you might be better off investing your money elsewhere. 

Using cash flow to measure financial performance 

A free cash flow margin shows the percentage of a company’s revenues that turns into free cash flow. Fevertree is impressive on this measure with a high and growing free cash flow margin. Anything consistently higher than 15 per cent should be seen as a sign of a very good business. 

Another option of calculating cash returns that doesn’t come entirely from numbers in a cash flow statement is something known as the cash return on cash capital invested (CROCCI). It compares a company’s Ebitda with the cash capital invested in the business. It can be used as an alternative to calculating return on capital employed (ROCE), which uses operating profits and capital employed that have both been reduced by a non-cash depreciation expense. 

The calculation for Fevertree is shown in the table below. On this basis, its financial performance is very impressive indeed. 

NIBCL is calculated by taking current liabilities from the balance sheet and taking away any short-term borrowing in that number.

The sources and uses of cash 

This isn’t used much, but is a useful way of understanding where a company gets its cash from and what it does with it. It is just another way of looking at cash flows and involves rejigging the cash flow statement. The difference between cash coming in and going out shows the change in the cash during the year. 

We can see that since 2013 Fevertree has moved from being a company that got most of its cash from loans and spent it on buying a company to one that gets most of its cash from selling products and using it to pay taxes and dividends. 

Using free cash flow to value shares 

The free cash flow yield is often used as a way of measuring how cheap or expensive a share is. High yields are seen as a sign of cheapness and vice versa. You can calculate it by comparing the free cash flow with the company’s market capitalisation or by calculating the free cash flow share and dividing that number by the current share price. 

Source: SharePad 

High quality, fast-growing businesses such as Fevertree are rarely available for a cheap price. Yet, even after a significant share price fall over the past few weeks, Fevertree shares look very expensive on the basis of their current and expected free cash flow yield. 

Free cash flow per share is expected to double between 2017 and 2020, but the shares still only offer a free cash flow yield of less than 2 per cent based on 2020 forecasts. In a world of rising interest rates on bonds, that doesn’t look great value unless free cash flow forecasts increase significantly as they have done in the past. 

Free cash flow yield is also a popular way of screening for undervalued takeover targets. A free cash flow yield of 10 per cent or more might attract the attention of bargain hunters, providing the free cash flow is sustainable.