You will be able to calculate free cash flow and explain why it is harder to dress up than profit.
Marcus's colleague owns a small SGX company that has reported a profit every year for a decade. It has also raised money from shareholders four times in that decade. Profit says the company makes money. The repeated fundraising says it doesn't keep any. The cash flow statement is where that contradiction becomes visible, and free cash flow is the number that settles it.
Figures for Larkspur are made up and in S$ millions.
Lesson 7.1, How the three statements tie together, traced Larkspur's operating cash flow from net profit. It's worth seeing the logic again, because every company's statement follows it.
Start with net profit: 48. Add back non-cash expenses, mainly depreciation: 24. Take out gains that don't belong in operations, such as the 6 from selling a property, whose cash shows up under investing. Then adjust for working capital: subtract increases in receivables and inventory, add increases in payables. For Larkspur that was minus 5, plus 2, plus 3. Operating cash flow was 66.
So operating cash flow is profit corrected for timing and for items that aren't cash. Over a long period, a healthy business's operating cash flow and profit should be broadly in line, with depreciation lifting cash above profit for capital-heavy firms.
Operating cash flow isn't money the company can hand out. It needs to keep its machines running and replace them as they wear out, and if it's growing it needs more of them.
Free cash flow is operating cash flow minus capital spending. For Larkspur in FY5, that's 66 minus 34: 32. It's the cash available, before any dividends, to repay debt, pay shareholders, build up cash or buy other businesses. Free cash flow is measured before dividends because dividends are one of the choices it pays for, not a cost of running the business.
Some analysts leave out proceeds from asset sales, as here, because a property can only be sold once. Others include them. Write down your choice and apply it every year.
Since leases moved onto the balance sheet under IFRS 16, lease payments are split. Repayment of lease principal goes in financing cash flow. The interest part goes in operating or financing cash flow, whichever the company's policy says. Before the change, the whole payment was rent, an operating cost.
The effect is that operating cash flow, and free cash flow calculated the usual way, now look better than they did, for exactly the same business. A company with heavy leases can show a big jump in free cash flow without anything changing except where the payments are recorded.
The fix is simple. Find lease principal repayments in the financing section, and calculate free cash flow both ways. Larkspur repaid 4 of lease principal in FY5. Free cash flow was 32 before leases, and 28 after. For Larkspur the gap is small. For a retailer, an airline or a company that leases all its premises, it can be most of the free cash flow.
When you compare companies, use the same version for all of them. Free cash flow after lease payments is closer to the cash an owner could actually take out.
Now compare free cash flow with profit. Larkspur's reported net profit was 48 and its underlying profit was 42. Free cash flow after leases was 28, about two thirds of underlying profit.
That gap isn't alarming in one year. Larkspur was growing again and rebuilding working capital, and it spent more on equipment than its depreciation, which is normal for a business adding capacity. The question is what happens over five or ten years. A business whose free cash flow runs persistently far below its profit is either investing heavily for growth that should show up later, or reporting profit that isn't turning into cash. The first is fine if the growth comes. The second is the pattern behind many accounting problems, and lesson 7.5, Earnings quality: accruals, cash conversion and red-flag scores, gives you the tests for it.
Marcus's colleague's company fitted the second pattern. Over the decade, its profits added up to far more than its free cash flow, which was negative in most years. The gap was filled by receivables that grew every year and by money from shareholders. The profit was real in an accounting sense. Shareholders kept paying for it.
Profit depends on many estimates: when revenue counts, how fast assets depreciate, how much inventory is worth, whether goodwill is impaired. Each one gives management room to choose. Cash depends on fewer choices. Money arrived in the bank account or it didn't.
Free cash flow can still be massaged at the edges, by delaying payments to suppliers at the year end, selling receivables to a bank, or classifying spending as investing rather than operating. But these tricks reverse within a year or two, and they show up in working capital days, which lesson 7.3 taught you to track.
For the activity, calculate free cash flow for five years of your company's accounts, with and without lease payments, and set each year beside its net profit.
Calculate free cash flow for five years, with and without lease payments, and compare it with net profit.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).