Personal Finance

What Does Negative Free Cash Flow Mean

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

How do you choose between the thousands of dividend-paying blue chip stocks available? When evaluating a company’s dividend potential, do you know what to look for?

Can you figure out if the high-growth companies that don’t pay dividends are spending more than they have? Free cash flow analysis is a useful tool for determining the vitality of a dividend-paying company or a growth stock.

The value of cash flow

Investors typically look at a company’s EPS to gauge its financial health. For publicly traded organizations, earnings data is readily available and is likely the most extensively reported metric. The difference from the actual currency is significant. Explain the distinction; why should I care either way?

When a company makes a sale, they record a profit. However, the customer may pay on credit, meaning the company may not get the money for months or even years. The possibility exists that the corporation will not get the funds in the worst-case scenario, such as when a customer defaults. 

Although the sale will be reflected in the company’s profits report right away, if the money isn’t actually in hand, it can’t be put to use.

Revenue is what really keeps a business afloat, even though profits are a useful accounting metric. Your investment’s value is cash flow, not earnings, which reflect operational efficiency and future potential. Despite having impressive profits, many businesses end up going bankrupt due to insufficient cash flow.

Companies require unrestricted cash flow

Cash flow from operations is the actual money a company earns from doing business as usual. 

To calculate this number, start with income and do the following:

  • Operational cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes

But there are a couple of flaws in this math: It does not consider investments in fixed assets and does not factor in dividend payments, both of which have a significant impact on a company’s ability to fund expansion and meet immediate needs with available cash.

Assume, for the sake of argument, that a business decides to spend heavily on new machinery and a fleet of cars in order to rapidly increase its asset base. Due to the routine nature of these expenditures, they would not have an impact on operating cash flow. 

To account for the need to invest in new assets, an equation must be developed to modify operational cash flow. Free cash flow is a helpful indicator in this case. Once capital expenditures are subtracted from cash generated from operations, the result is known as free cash flow.

  • Free cash flow = Operational cash flow – Capital expenditures – Dividends

The term free cash flow is used to describe the amount of money still available after a corporation has paid for its fixed assets and its dividends. Think about a case to see how earnings differ from free cash flow.

Example of Free Cash Flow Analysis vs. Earnings

A fresh startup with big ideas launches a sleek new product. The production of this novel widget is cheap and may result in substantial profits for the business. Consequently, the firm pours resources into production and advertising. 

The company expands by purchasing new stores and constructing new warehouses. Since downtown Manhattan is such a desirable site, the new stores and warehouses there have high initial costs despite little depreciation.

Widgets are a huge success, and the business reaps substantial profits. However, the profits do not account for the astronomical price tag of the downtown site or the steep expense of growth. While profits increase, the company will not have enough cash on hand to expand. 

In the absence of increased profits, the value of the company’s stock will plummet, and it will have difficulty raising the capital it needs to finance its planned expansion.

In order to stay afloat, the company will have to issue more debt bonds or equity shares, which will further dilute existing shareholders’ holdings and hurt the company’s stock price.

Why didn’t management notice the potential problem sooner, and how could that be avoided? An examination of free cash flow would have shown how quickly the corporation was sinking into an unsustainable spending pattern. 

What would it cost the business to run for three months?

  • Sales (50% credit and 50% in cash): $100 million
  • Cost of goods sold (materials and labor): $50 million
  • Depreciation: $1 million
  • New asset purchases: $50 million

It appears that the company made an amazing $49 million throughout the quarter. Cash flow from operations, however, paints a much gloomier picture. Given that 50% of purchases are on credit, they have just $50 million in readily available cash. 

With a total of $50 million in direct costs of goods sold, there will be no money left over after paying all operating expenses. The corporation spent $50 million it didn’t already have on the acquisition.

High-growth earnings provide a positive picture, but without free cash flow, the company will either be unable to develop or will be forced to do so in ways that are detrimental to the share price. The possibility of the corporation filing for bankruptcy cannot be discounted.

Analysis of Stocks’ Free Cash Flow

For a real-world illustration, let’s look at what Brookfield Properties has done (NYSE: BPO). They have commercial properties in both North America and Australia, which they own, develop, and manage. They’re also in the business of building new neighborhoods. 

Their revenue expansion appears to be phenomenal:

  • One-year earnings growth: 407%
  • Three-year earnings growth: 78.8%
  • Five-year earnings growth: 51.6%

The stock price should be flying based on earnings, but it isn’t. Even though share prices have increased by about 40% over the previous year due to the stock market recovery, they are still down by more than 26% from their 2006 highs. BPO may have been able to prevent the situation if it had looked at free cash flow. 

Even as early as 2004 and 2005, the issue was becoming apparent:

  • 2004 operational cash flow: $459 million
  • 2005 operational cash flow: $230 million
  • 2006 operational cash flow: $66 million

Financial backers should have signaled alarm at the first sign of declining cash flow, but all was far from lost. In spite of a decline, the company was nevertheless able to generate positive operating cash flow. 

Information can be gained from capital expenditures.

  • 2004 capital expenditures: $81 million
  • 2005 capital expenditures: $179 million
  • 2006 capital expenditures: $159 million

When cash flows from operations were subtracted from capital expenditures, BPO had $378 million, or about $1.08 per share, in 2004, $51 million, or about 27 cents per share, in 2005, and a negative $93 million, or about 27 cents per share, in 2006. 

The company was obviously experiencing cash flow issues, but huge dividend payments were still being made by Brookfield notwithstanding this.

  • 2004 dividend payout: $94.8 million ($0.27/share dividends x 351 million shares)
  • 2005 dividend payout: $149.7 million ($0.43/share dividends x 348.15 million shares)
  • 2006 dividend payout: $174.3 million (derived from $0.50/share dividends x 348.6 million shares)

You can’t keep doling out the cash you don’t have, as any good accountant or investor would tell you. When cash reserves are depleted, a quick review of free cash flow might summarize the severity of the situation:

  • 2004 free cash flow: $280.8 million ($0.80/share dividends x 351 million shares)
  • 2005 free cash flow: -$95.5 million (-$0.28/share dividends x 348.15 million shares)
  • 2006 free cash flow: -$261.5 million (-$0.75/share dividends x 348.6 million shares)

You can’t keep doling out the cash you don’t have, as any good accountant or investor would tell you. When cash reserves are depleted, a quick review of free cash flow might summarize the severity of the situation:

  • 2007 free cash flow: -$692.8 million(-$1.75 per share x 395.9 million shares)
  • 2008 free cash flow: -$337.4 million (-$0.86 per share x 392.3 million shares)
  • 2009 free cash flow: -$232.6 million (-$0.54 per share x 430.7 million shares)
  • 2010 free cash flow: -$612.2 million (-$1.22 per share x 501.8 million shares)

In order to obtain additional capital, BPO has issued additional shares, reducing the proportion of ownership held by current shareholders. The number of outstanding shares increased from about 348 million in 2006 to over 500 million in 2010. 

A reduction of over 44%! It will continue to have trouble making ends meet until the company can increase its free cash flow. Earnings figures merely don’t convey the complete story, especially in the midst of substantial capital expenditures and dividends.

Bottom Line

Revenue or free cash flow? You need to keep tabs on both sets of figures now that you know how to use each one. 

For this calculation, we employ a more gradual reduction of capital expenditures by depreciating assets, which provides a nice picture of a company’s day-to-day operations and long-term viability. 

In contrast, free cash flow is the net amount of money that a company has after deducting the cost of investing in new assets and paying out dividends.

The absence of liquidity can pose serious risks, and free cash flow can help you avoid them. The ability to fund capital expenditures and maintain dividend payments can be gauged by tracking the growth or decline in a company’s reported free cash flow.

Be wary of investing in a blue chip stock with declining free cash flow because this often indicates a future dividend cut or elimination. In contrast, it may be worthwhile to ride out a period of negative free cash flow if the company is young and experiencing rapid growth.

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