Chapter 7
Tracking Cash with the Statement of Cash Flow
IN THIS CHAPTER
Discovering the key parts of the statement of cash flows
Understanding how the statement of cash flows can give you a picture of a company’s finances
Digging into why a company’s cash flow can be more telling than monitoring its earnings
Figuring out how to monitor a company’s free cash flow and cash burn rate
“Show me the money!” Profits and assets are great. But there’s something comforting to investors and fundamental analysts alike about cold, hard cash. That’s where the statement of cash flows comes in.
Accounting rules can become so convoluted it’s hard to simply see how much cash a company is bringing in the doors. You might read through a company’s income statement and balance sheet and feel as if you have a pretty decent understanding of how the company is doing and what it owns. But revenue and profit are just numbers on a financial statement. It’s cash that really matters. It’s cash that pays the bills.
The statement of cash flows, or cash-flow statement, is all about showing you the money. The statement meticulously tracks the flow of actual cash in and out of a company. There’s nothing more reassuring than knowing a company is bringing in cash, not just playing accounting games with the income statement.
Fundamental analysts revel in the brutal honesty of the cash-flow statement. And while the statement has its limitations, in this chapter you’ll find how tracking the cash flowing in and out of a company can take your analysis skills to the next level.
Looking at the Cash-Flow Statement As a Fundamental Analyst
To understand why a company’s cash flow can be more revealing about a company’s performance than the income statement, consider this simple example. Imagine your daughter has borrowed $10 from you to start a lemonade stand. The only stipulation of the loan is that she reports back to you on how the business is going.
Excited about being an entrepreneur, your daughter quickly spends the $10 you lent her to get up and running. She buys lemons, sugar, cups, and stirring spoons. It’s a hot summer day, so it looks like a winning business idea. What could possibly go wrong?
At the end of the day, you ask your daughter how she did. Hardly able to contain her smile, she beams business was great and she completely sold out of lemonade. She estimates she sold 50 cups of lemonade at 50 cents a cup. You do the math quickly and determine her profit was $15. Constructing an income statement in your head, as explored in Chapter 5, you calculate she brought in revenue of $25 (50 cups of lemonade at 50 cents) and spent $10 to make the product. That’s a net income of $15.
But when you extend your hand to ask for your $10 back, thinking you’d let her keep her $5 portion of the total profit, she reports she doesn’t have any cash at all. It turns out that she accepted IOUs for all the lemonade she sold. Suddenly the business isn’t necessarily looking so good, because there’s no cash flow.
This example is a gross simplification. But it gets to the point of why cash flow is critical to analysis. Cash matters.
Accounting rules, even if properly followed, may give the impression a company is doing better than it really is. Profit or net income, as measured by rules made by accountants, is subject to dozens of estimates, approximations, and hunches. But cash is cash. You either have it or you don’t.
Getting into the flow with cash flow
You might be wondering why you need to even bother with the statement of cash flows. After all, the income statement, explored in Chapter 5, tells you how profitable the company is. And the balance sheet, discussed in Chapter 6, tells you how solid a company’s financial resources are.
The statement of cash flows, though, deserves a spot in your fundamental analysis routine. The statement can provide valuable information when evaluating a company because it:
- Cuts through the optics of accounting. As you learned in Chapter 5, measuring a company’s profit is a pretty convoluted process. There are even more machinations going on behind the scenes, as accountants classify expenses and revenue. In contrast, cash is cash. You either make cash profits or you don’t.
- Links the different financial statements together. The income statement and balance sheet are somewhat independent of each other, because they’re measuring different aspects of a business. The statement of cash flows, though, draws upon information from both the income statement and balance sheet to give you one, complete view of the company.
- Highlights cash generated from actually doing business. The statement of cash flows makes it very clear how much of the cash coming into a business is the result of the company actually selling its products and services. It’s a helpful way to look past some one-time gains a company might receive, say, by selling assets.
Accounting standards were tightened in the early 2000s following the implosion of failed energy trading firm Enron. New rules are routinely approved by accounting standards–setting groups to make the income statement less subject to manipulation. Even so, the income statement is to be regarded with some healthy skepticism. The statement of cash flows can let you intelligently look for potential red flags in a company’s accounting, which is one of the hallmarks of fundamental analysis.
Remember your daughter’s hypothetical lemonade stand from earlier. The same sort of thing can happen with larger companies. Imagine a company so eager to book revenue that it offers customers, who agree to buy products or services now, a very lenient repayment schedule. Doing so would allow the company to book revenue now, boosting net income. That would make unsuspecting investors happy. The trouble, though, is that the company is essentially stealing net income from a future period. When companies do this, it’s referred to as channel stuffing, because the company is pushing product into the hands of customers prematurely to book sales now. The statement of cash flows, however, makes channel stuffing easy to spot, because the company didn’t receive cash.
Breaking the cash-flow statement into its key parts
The statement of cash flows is divided into three main sections. The strict organization allows you to isolate which part of the business you want to examine. Cash coming into or going out of a company is placed into one of three categories, including:
- Cash flows from operating activities. Here, investors get a good idea of how much cash a company brings in, or uses, during its normal course of business. This section of the statement of cash flows counts cash coming in from customers as well as cash used to pay suppliers for materials, to the government for taxes, and to pay workers’ salaries.
- Cash flows from investing activities. Companies keep careful track of money they’ve spent upgrading, or investing in, themselves. This section, for instance, counts the cash consumed buying new assets such as equipment or facilities.
- Cash flows from financing activities. While companies are generally hoping to become self-sufficient and support their operations with the cash they generate from their business, sometimes they need cash injections. This section of the cash-flow statement tallies up how much cash is plowed into a company by lenders and investors. Want to know what’s using up a company’s cash? That’s in here, too. This section of the cash-flow statement accounts for cash that’s flown out of the company, including to pay cash dividends to investors or to pay down debt.
Unfortunately, many companies aren’t as forthright with their statements of cash flows as they are with the balance sheet and income statement. When companies report their earnings using earnings press releases, a vast majority do not provide a statement of cash flows. You can read more about what’s contained in the earnings press release in Chapter 4. You may need to wait for weeks after a company reports its earnings before getting the statement of cash flows. Companies are required to include the statement in their 10-Q or 10-K filings.
A few companies including Amazon.com, though, have started providing a statement of cash flows with their earnings press release. That’s a positive trend for fundamental analysts that other companies will hopefully follow.
Examining a company’s cash flow from operations
You’re following the money, so you might as well start at the top. The first section of a company’s statement of cash flows deals with measuring how much cash a company brings in during its normal course of business. This key section measures cash from operations, or formally called cash provided by (used in) operating activities. The section tells you how much cash the company generated, or used, in the course of doing business. If you’re curious what this part of the cash-flow statement looks like, flip ahead and take a peek at Table 7-2. You’ll see the cash from operations portion of Mondelez International’s statement of cash flows presented there so you can follow along with the descriptions of each line item. Mondelez is a giant food company that owns brands like Nabisco, Chips Ahoy!, and Wheat Thins.
Reading the statement of cash flows can get complicated because there are many lines in the statement. Adding to the confusion is the fact some of the lines are positive and some are negative. Don’t stress. Just remember the statement of cash flows is really just converting a company’s net income into a number that represents a company’s cash flow. Also, remember when a number in the cash-flow statement is positive, that means the activity brought cash into the company. Similarly, when the number is negative, the item chewed up cash. If you’re more of a visual person, Table 7-1 shows you how to think of these adjustments.
TABLE 7-1 Generating or Consuming Cash
If an Item on the Cash Flow Statement Is … | It … |
|---|---|
Negative | Uses cash |
Positive | Generates cash |
You may wonder exactly what kinds of things generate or consume cash — or what other adjustments are made to the income statement to calculate the cash-flow statement. The following sections outline some of those adjustments.
Depreciation and amortization
Usually, the biggest adjustments to net income to convert it into cash from operations are depreciation and amortization. Depreciation is an expense companies are required to include on their income statement that doesn’t actually cost a company cash. Depreciation tallies the expense of the wear and tear on its equipment. Amortization, on the other hand, is the erosion of value of intangible assets, like patents or trademarks. Depreciation, most of the time, is added back to net income as the first step to measure the company’s cash flow.
Depreciation can be a somewhat difficult item for investors to understand. Think of it this way. Every year, the value of your car falls due to age, and wear and tear. It’s a real expense, because it is technically costing you money. But when your car depreciates, you don’t get a bill for it. You don’t have to write a check, and it doesn’t cost you cash immediately. As a result, depreciation is added back to net income when measuring a company’s cash flow from operations.
Stock-based compensation expense
Getting top talent is a key part of business success. Sometimes companies get into an arms race trying to attract the best employees and management. Paying these employees could be a serious drain on a company’s liquidity if they were paid in all cash. Some smaller companies, which don’t exactly have money to spare to pay high-priced talent, can’t compete on cash. Some enterprising companies found out they could give out stock or stock-based awards to employees and management instead. Employees are happy if the stock price goes up. Companies also score because they don’t have to give up cash. Accountants require companies to include the value of stock-based compensation on the income statement, because it’s a real expense. But stock-based compensation is added back to net income to derive cash from operations because no cash actually changed hands.
Tax adjustments (also called deferred income tax benefit)
Companies keep two sets of books. There’s one set for investors, which measures earnings according to the accounting rules. Then there’s a set required by the Internal Revenue Service for taxes. The different sets of books have different rules. As a result, a company may pay taxes to the IRS before the tax expense is recorded in the books monitored by accountants. The opposite can also happen when a company earns income but didn’t owe tax yet. Confused yet? Don’t worry. Just know that when a company actually writes a check and pays taxes, which aren’t recorded on the income statement, it must subtract the amount from net income. It’s subtracted, because paying the taxes ate up some of the company’s cash.
Gains on divestitures
When a company sells a unit, it may add the profit on the sale to its net income. But remember, that profit didn’t result from the company selling products or services. Because the sale didn’t generate sales from operations, the amount is subtracted from net income.
Asset impairments or losses on sales of discontinued operations
Believe it or not, companies sometimes make poor business decisions. They might try a new business concept, which flops spectacularly, or realize an asset they bought has lost its value. When companies are hit with these charges, accountants consider them to be costs and require the companies to take a hit to the income statement. However, savvy fundamental analysts know many of these flops don’t actually cost companies cash. And that’s why many of these charges are added back to net income to arrive at cash from operations.
Accounts receivable
If you’re worried about a company claiming it’s doing better than it really is, this section of the cash flow statement is critical. As you discovered in Chapter 6, a company’s accounts receivable is a tally of how much its customers owe for products they’ve bought. If you see accounts receivable soar, that means customers are mostly buying on credit instead of paying cash. The increase in accounts receivable eats into a company’s cash because the company is essentially giving customers a credit card.
If you’re worried a company might be stuffing the channel, pay close attention to the change in accounts receivable. A big jump in accounts receivable compared to the increase of a companies’ revenue can be a tip-off.
Accounts payable
When you buy something using a credit card, you get the asset without using cash. It’s the same concept with companies, which may buy supplies or materials on credit. They’re able to get their hands on the things they need to conduct business, without using cash. When a company’s accounts payable increases, it’s considered a boost to cash and added to net income.
If you notice accounts payable is rising relative to a company’s cost of goods sold (discussed in Chapter 6), watch out. It might mean the company isn’t paying its bills on time, which may inflate its cash.
Inventories
If you’ve ever read about just-in-time manufacturing, you understand why companies go to great lengths to keep inventories low. Buying piles of materials needed for business consumes precious cash. So by keeping inventory levels down, companies can hang onto cash. You’ll see this immediately on the statement of cash flow. If inventories rise, the increase is subtracted from net income to measure a company’s cash from operations. Likewise, if a company uses up inventory, it’s a boost to its cash levels.
Other
Individual companies can go through unique events that affect their net income but not their cash situation. The events must be added back and subtracted from net income, but they might not appear in other companies’ statements of cash flows. Mondelez had several such events in 2021, such as an expense associated with the early extinguishment of debt, which didn’t cost it cash. Accountants also let the company take a small net income gain for a financial instrument used to sell some businesses. But because the deal didn’t boost the company’s cash after accounting for associated costs, it is subtracted from net income to calculate cash from operations.
Net cash provided by (used in) operating activities
Here’s the end-all-be-all when it comes to measuring a company’s cash flow from its operations. After making all the painstaking adjustments to net income, to add back items that didn’t use cash and subtract those that did, you get a company’s cash from operations or net cash provided by (used in) operating activities (see Table 7-2).
TABLE 7-2 Mondelez’s Cash From Operations in 2021
Item | Amount (in Millions) |
|---|---|
Net income | $4,314 |
Depreciation and amortization | 1,113 |
Stock-based compensation expense | 121 |
Deferred income tax benefit | 205 |
Gains on divestitures | –8 |
Asset impairment | 128 |
Loss on early extinguishment of debt | 110 |
Change in accounts receivable | –197 |
Inventories | –170 |
Accounts payable | 702 |
Other | –2,177 |
Net cash provided by operating activities | 4,141 |
Source: Data from Mondelez International’s 2021 10-K
When net cash provided by (used in) operating activities is positive, that means the company generated cash from its normal line of business. If the number is negative, that means the company burned cash. Some companies will put the negative number in parentheses while others make the number red in the financial statements.
Considering a company’s cash from investments
When you buy a company’s stock, you want to make sure it’s making adequate investments in itself to keep things in working order. That’s where the section of the cash-flow statement, called the cash from investing or cash provided by (used in) investing activities comes in.
This part of the cash-flow statement shows you how much cash the company is using to keep its factories humming or stores looking presentable. Generally, investments companies make in themselves can consume large amounts of cash for things including:
- Updating stores to remain relevant. A retailer, for instance, may need to periodically remodel stores to keep them interesting to shoppers.
- Enhancing capacity. A manufacturer that’s running full tilt may need to add warehouse space to handle increased demand.
- Upgrading equipment. A hospital may be able to improve patient satisfaction and reduce wait times by buying a state-of-the-art device that works faster or is more effective.
- Acquisitions. Companies might decide it’s cheaper to buy a rival that’s already in an area of business, instead of trying to launch its own business.
- Divestitures. When companies sell off a unit, they typically receive cash. That cash isn’t coming from operations — or from the company selling its goods or services. It’s from investing; at least that’s what the accountants say. Even if a company technically lost money on a unit that’s sold off, if it gets at least some cash, that’s still considered a positive cash flow.
For simplicity, companies will often lump all their investments in improving, enhancing, or updating their facilities into a single item on the cash-flow statement called capital expenditures, or cap ex for short. If you’re interested in digging more deeply into what capital expenditures a company made, the details will be provided in the footnotes in the 10-K.
Table 7-3 takes a look at the investments Mondelez made to its business in 2021. Notice the huge drain of cash from capital expenditures — remember that when cash is used, the number is shown as a negative or in parentheses. Mondelez’s statement of cash flows is a good reminder of how cash flows can be erratic. The company also spent big, $833 million in cash, on acquisitions in 2021. That’s been a recurring theme at the company, which spent $1.1 billion and $284 million, in 2020 and 2019 respectively, buying companies. On January 3, 2022, Mondelez spent nearly $2 billion for a croissant and baked good company serving central and eastern Europe. It also sold a few businesses, which brought in cash.
TABLE 7-3 Mondelez’s Cash from Investing Activities in 2021
Item | Amount (in Millions) |
|---|---|
Capital expenditures | ($965) |
Acquisitions | (833) |
Proceeds from divestitures | 1,539 |
Other | 233 |
Net cash (used in) investing activities | (26) |
Getting into a company’s cash from financing activities
Companies are often like politicians: They seem to be constantly raising money. Instead of trying to line up financing for their campaigns, though, companies need funding to keep themselves going.
A classic example would be a young retail company. The company may not have enough cash to buy all the shirts, pants, and shoes it needs to put into its store. The retailer, then, might borrow money to buy the merchandise, and plan to pay it back after the goods are sold. The money borrowed is considered a positive cash flow from financing activities.
A company’s financing activities may bring in or use up cash in a variety of primary ways. Generally, cash is brought in by borrowing money or selling stock to investors. All this is summarized right in the cash from financing activities section of the statement of cash flows. Table 7-4 shows an example again using Mondelez. The biggest uses or generators of cash from financing activities include:
TABLE 7-4 Mondelez’s Cash from Financing Activities in 2021
Item | Amount (in Millions) |
|---|---|
Short-term debt issued (net of repayments) | $194 |
Long-term debt issued | 5,921 |
Long-term debt repaid | (6,247) |
Repurchase of common stock | (2,110) |
Dividends paid | (1,826) |
Other | (1) |
Net cash (used in) investing activities | (4,069) |
Increasing or decreasing the company’s debt load: As you discovered while reading about the balance sheet in Chapter 6, companies can finance themselves by using their profits, by borrowing or by selling stock to shareholders. Each of these forms of raising cash has its advantages and disadvantages.
This section of the statement of cash flows shows whether or not a company is generating cash by issuing debt or using cash by repaying back debt. If a company decides it has borrowed too much, for instance, it may choose to use cash to pay down its debt.
The statement also distinguishes between its short-term debt and long-term debt. Short-term debt is most pressing, as it’s due within a year, while long-term debt matures in more than a year. Mondelez in 2021 issued more than $6 billion in new long- and short-term debt.
- Buying back (or repurchasing) the company’s stock: From time to time, companies might choose to buy their own stock. When they do this, they use cash to take shares out of the hands of the public by buying them. This reduces the number of slices a company’s profits are cut into, potentially making each share more valuable.
- Paying out dividends to shareholders: Some companies, usually those in mature businesses with stable cash flow, might generate more cash than they need to run themselves. These companies generally will return cash to shareholders by issuing dividends. These payments consume cash.
- Net cash provided by (used in) financing activities: After accounting for all the cash brought in by borrowing and issuing stock, and cash used by extinguishing debt, buying back stock, and paying dividends, you get the final result. Net cash provided by (used in) financing activities, or cash from financing activities, shows you whether the company was a net gainer or user of cash after considering all money-raising events.
How Investors May Be Fooled by Earnings, But Not by Cash Flow
Investors often pay very close attention to a company’s revenue and profits. Too much attention, probably. Every quarter, during so-called earnings season, investors look at what companies said they earned, compare those results with what investors were expecting, and either buy or sell the stock.
The fact investors pay such close attention to earnings is not missed by companies’ managements. There’s a big incentive for companies to never miss earnings expectations, or how much investors think the company will make, because doing so can cause a stock price to fall precipitously. Adding to the incentive to not disappoint: Many executives’ pay packages are closely tied to the companies’ stock price. If earnings disappoint and the stock falls, there goes the Hawaiian vacation for the CEO.
Not only is there an incentive to meet earnings expectations, there’s a way, too. The flexibility of accounting rules allows management to manage earnings. The term manage earnings describes a whole host of things management can do to even out net income and earnings each quarter, and reduce the chances of disappointing investors.
Management’s ability to manage earnings largely stems from the way the income statement is constructed. Generally, financial transactions use accrual accounting. Accrual accounting records revenue when sales are made, and costs when they’re incurred. That is very different from cash accounting, which records revenue when sales are collected and costs are paid.
When a company’s profit is widely different from the cash it’s bringing in, that’s something of great importance to a fundamental analyst. I’ll show you how fundamental analysts watch for this potentially disturbing trend later in this chapter.
Companies can also inflate the cash. The most common way would be to avoid paying their bills. Eventually, though, this tactic will catch up with a company when its suppliers or other creditors threaten legal action or stop shipping supplies and raw materials.
You can spend hours analyzing the statement of cash flows. Later in the book, I’ll share with you some financial ratios and other things you can do to analyze the cash coming into and out of a company.
But here, I want to share with you one of the fastest and most effective fundamental ways to analyze a statement of cash flows. It’s such a simple form of analysis, it’s not a bad idea to do with any company you invest in or have an interest in.
If you recall, profits certainly are important. But cash flow is king. You could have a company reporting giant profits according to the income statement, but not actually bringing in the cash. Remember the lemonade stand discussed earlier in the chapter? Don’t be fooled by this maneuver by doing one simple thing: Compare a company’s net income with its cash from operations. It’s very simple fundamental analysis to do. All you need is the company’s statement of cash flows.
Here’s what you’re looking for when you do this analysis: If a company is generating as much cash as it’s reporting in net income, that can be a good indication it has high-quality earnings. High-quality earnings are those that are backed up by cold, hard cash, not just smoke and mirrors made possible from accounting rules.
If this analysis seems confusing, keep reading. When you follow these steps and practice a few times, you’ll be surprised at how easy it is to compare a company’s net income with its cash from operations.
Don’t assume the tightening of accounting standards in the early 2000s stomped out low-quality earnings. Financial accounting standards have been considerably tightened over the years — especially following a few major meltdowns like Enron. Even so, the number of firms with lower-quality earnings have been creeping up again. Interestingly, in 2021, the number of S&P 500 companies with low-quality earnings hit the highest level seen in five years. It’s typical for companies’ earnings quality to fall during a bull market. Why? Investors are willing to look past low earnings quality when stocks are rising. But that changes fast when the market falls, as it did in early 2022. Table 7-5 shows the number of companies in the Standard & Poor’s 500 that reported net income that was greater than their cash from operations.
The following steps show you how to perform this form of cash-based earnings-quality analysis on Mondelez:
- Look up the company’s net income. As you learned in Chapter 5, a company’s net income is available on the income statement. But you can also take it from the very top line of the statement of cash flows. For Mondelez, net income was $4.3 billion in 2021.
- Look up the company’s cash flow from operations. Cash flow from operations is how much the company generated from its business. It’s kind of like the cash version of net income. If you recall, Mondelez’s cash flow from operations was $4.1 billion in 2021.
TABLE 7-5 Earnings Quality Rises and Falls
Year
Number of Companies in the S&P 500 with Higher Net Income than Cash Flow from Operations
2021
95
2020
52
2019
62
2018
61
2017
81
Source: Adapted from S&P Global Market Intelligence. Based on members of S&P 500 as of July 2022 cash flow and net income based on calendar years.
- Compare net income with cash flow from operations. You’ll want to see cash flow from operations be at least equal to, if not larger, than net income. That tells you that the company is generating as much cash as it purports to generate in earnings. Table 7-6 summarizes what you need to know. For instance, at Mondelez, the company brought in roughly $200 million less from cash from operations than it reported as earnings in 2021. It’s worth noting, yes. But the two numbers are still close enough to give you decent confidence that the company has acceptable quality earnings.
TABLE 7-6 Sizing Up a Company’s Earnings Quality
If Cash from Operations is … | It Means the Company … |
|---|---|
Greater than net income | Generates more cash than it reports to shareholders as earnings. It has high-quality earnings. |
Less than net income | Generates less cash than it reports to shareholders as earnings. It has low-quality earnings. |
Just because a company’s net income is less than its cash flow from operations doesn’t mean it’s committing fraud, as in the case with Mondelez. It just means a substantial portion of the profit it’s reporting isn’t materializing in cash. This might happen, for instance, when a fast-growing company sells goods so rapidly it must book profits before it can collect cash from customers. It may also be an issue with the company building up inventories to mitigate supply-chain problems, which uses up cash. Still, when you see cash flow from operations that’s less than net income, it’s a reason to be concerned enough to dig further to determine the cause.
Understanding the Fundamentals of Free Cash Flow
Face it. Earnings may impress investors, but cash flow pays the bills. Even if a company posts remarkable revenue growth, if it can’t get money into the doors fast enough to pay its own bills, it’s toast. That’s where a popular financial measure called free cash flow comes in. Free cash flow tells you how much cash a company generates (or uses) during the normal course of doing business, including the cost of upgrading and maintaining its equipment and facilities. Free cash flow is essentially an adjustment to cash from operations to include some of the company’s investing activities.
Just remember free cash flow is a relatively easy fundamental analysis tool that can tell you a great deal about a company’s generation or burning up of cash. Watching a company’s free cash flow is kind of like watching the fuel gauge when you’re driving. Just as you want to know when fuel is running low, you want to know when cash is drying up.
There are many ways to analyze cash flow. Some analysts try to determine how much cash a company is throwing off by studying earnings before interest, taxes, depreciation and amortization, or EBITDA. EBITDA adjusts a company’s net income by adding back interest, taxes, depreciation, and amortization. EBITDA can be another way to study how profitable a company is and offers a rough idea of how able a company is to pay its interest costs. But don’t make the mistake of assuming EBITDA is a company’s cash flow, even though many analysts do. EBITDA doesn’t factor in the cash eaten up by inventory, extending credit to customers or used to buy new equipment. Trust me on this one. When you want to know how much cash a company is using up, rely on free cash flow as described in the following section.
Calculating free cash flow
The term free cash flow might sound pretty complex and academic. But you might be surprised at how easy it is to calculate a company’s free cash flow. Everything you need to measure free cash flow is available on the statement of cash flows. How convenient!
In fact, if you’ve followed the calculation of a company’s cash from operations in the “Examining a company’s cash flow from operations” section, earlier in this chapter, you’re more than halfway to arriving at free cash flow. The formula for free cash flow looks like this:
Free cash flow = Cash from operations – Capital expenditures
Again picking on Mondelez as an example, you can calculate the company’s free cash flow by subtracting its capital expenditures of $965 million from its cash from operations of $4.1 billion, to arrive at free cash flow of $3.1 billion. Mondelez is generating cash. But that’s not always the case. In the next section of this chapter, I show how to analyze a company that’s burning through cash and see how long it takes before it burns through its entire wad.
Some beginning fundamental analysts are uncertain why capital expenditures should be subtracted from cash flow from operations to arrive at free cash flow. The idea is a company cannot continue very long without reinvesting and upgrading its infrastructure. The example of a manufacturing company is especially helpful. After a certain period of time, machinery that’s left with no maintenance will break down or not work properly. Putting money into keeping up equipment is critical if a company is to remain in business.
Measuring a company’s cash-burn rate
One of the great reliefs of reality shows is that eventually, the contestants with no talent finally get the boot. Whether it’s the singer with the horrible voice in America’s Got Talent, the underperforming cook on Hell’s Kitchen, or the clumsy contestant in The Masked Singer, eventually those who don’t belong are eliminated.
The same brutal and harsh reality applies in the business world. Except companies don’t trip or choke — they run out of cash. Companies that run out of cash are often history (unless they’re able to get a bailout). And as a fundamental analyst, it’s important to understand how this Darwinism works.
When a company relies on borrowed money, the death toll occurs when a company misses interest payments on its debt. At that point, lenders can take over the company and force it to restructure. But what if a company hasn’t borrowed? For these companies, the music stops when they run out of cash.
At this point, you have all the basic skills you need to measure when a company will run out of cash, or perform what’s called a cash-burn analysis. When you do a cash-burn analysis, you measure how long a company’s cash pile will last if it continues to consume cash at its current rate. Think of yourself as a doctor telling a patient how many months they have to live.
You may not remember the dot-com boom of the 2000, which is a shame, because it was perhaps the best example in recent times of the dangers of running out of dough. Some of the best examples ever of cash burn occurred during this period of time when the Internet was new with investors. Several Internet companies raised gobs of money during the boom. But after the Internet bubble burst, many were unable to either sell stock or borrow. That meant they only had the cash they’d saved to survive on.
Because many Internet companies were losing money and burning cash at such a rapid pace, they stood to run out of cash before they could ever make a dime for investors. In April 2000, USA Today found that three of the 14 largest online retailers would burn through their cash piles in less than 12 months. All three ended up either filing for bankruptcy protection or being acquired by rivals for pennies a share, all but wiping out investors.
This formula can help you steer clear of these situations:
Number of years the company will have cash = Cash and cash equivalents ÷ Annual free cash flow
If the company burned cash, it will have a negative free cash flow. Convert it into a positive number before using the formula just given.
An example is Value America, an online retailer that was a darling on Wall Street during the Internet boom. You’ve probably never heard of it, but trust me, at the time people thought it might give Amazon a run for its money. Investors just wanted to own Internet stocks — whether they generated cash or not. Value America took advantage of the generosity of the investing public by selling 5.5 million shares at $23 a share. Selling the stock generated $126 million in new cash. Investors loved it and sent the stock up 140 percent on its first day of trading.
Here’s the problem: The company was using up cash faster than it could raise it. During 1999, the company burned $109.9 million in cash from operations. Value America spent an additional $16.3 million for capital expenditures. Adding the two numbers together, Value America’s free cash flow was a negative $126.2 million. Meanwhile, the company ended 1999 with cash and cash equivalents of $52.1 million.
Use the formula 52.1 ÷ 126.2 = 0.4. In other words, Value America didn’t even have enough cash to last it a year. It only had enough cash to last it four-tenths of a year. It’s helpful to convert the 0.4 into a time frame, by multiplying 0.4 by 12 to see how many months the cash will last. The result? Value America had just enough cash to survive just shy of five months.
That might have been fine if investors were still willing to throw silly amounts of money at Internet companies. Companies like Value America could continue to burn cash — and simply refill their coffers by selling stock. But after the tech bubble burst in 2000, investors weren’t willing to invest anything in dot-coms, especially those losing money and burning cash. And guess what? Value America filed for bankruptcy protection in 2000. Fundamental analysts pay close attention to companies’ cash-burn rates because companies must generate enough cash to become sustainable.
It’s easy to look back and think how investors in 2000 were total fools. Why wouldn’t they look at cash burn? But although there hasn’t been a mania in cash-burning companies of this magnitude since then, it’s pretty common for investors to get overly enamored with some equally speculative companies. It’ll be interesting to see how the flurry of small companies that went public in 2020 and 2021 will hold up.