Free cash flow determines a company’s health and financial fitness. If one thinks of a company (or a castle) as though it functioned like the human body, then cash flow would be the company’s lifeblood. Blood flows through the human body, carrying oxygen and nutrients to organs that help maintain bodily functions. When the body is starved of blood, bad things happen. The same is true with cash and a company. When a business is starved of healthy cash flow, it is difficult to invest in the company’s growth.
The important thing to remember is that free cash flow depends on several business parameters, such as revenue, gross margin, operating expenses (OPEX), capital expenses (CAPEX), working capital, debt repayments, interest payments, and taxes.
A general manager’s goal is to optimise these different parameters to maximise the resultant free cash flow. Since free cash flow is dependent on these parameters, it is a diagnostic indicator of how a business is managed. This is the reason I use it as my key indicator of the health and strength of a company.
In summary, free cash flow is a measure of financial fitness because it funds day-to-day operations, gives investors the confidence to lend the company money, enables the company to pay interest on money borrowed, helps the company to weather periods of uncertainty, and allows for investments that help the company grow.
If free cash flow is a key indicator of business health and fitness, then how much of it should a business generate? Is there a metric or rule that one can use as a guideline? There is. I will provide a simple guideline here that serves as my Golden Rule.
Tina, an entrepreneur, had dreamed of having her own toy and game store since she was a young girl. She founded Tina’s Toy Shop, a small business, by borrowing $1 million from a bank at an annual interest rate of 5 per cent, with the obligation to pay back the principal after ten years. The interest rate is the cost of borrowing money for this small business. The bank expects to get $50,000 in interest payments every year. Let us say Tina’s Toy Shop makes a profit from its operations of $60,000, after taxes. This profit can be used to pay the interest on the loan, leaving $10,000 left over. Let us call this the toy shop’s retained earnings or savings. On the other hand, what happens if, due to an economic downturn, the toy shop makes a profit of $30,000 in one year? This profit is less than $50,000, and the toy shop cannot make its full interest payments unless the owner dips into the company’s retained earnings or savings. If this imbalance continues for more than a year, the bank is going to get worried because the small business may not be able to meet its interest payments or repay the money lent and may default. To be solvent, the small business must generate more than $50,000 in profit each year to pay the bank and have money left over to run its operations. If it generates significantly more than $50,000, the bank would be happy and might even lend it more money to grow.
This is the Golden Rule – generate enough cash to meet all your financial obligations and bolster investor confidence to invest in your business. Next, let us quantify this rule.
Tina is very enterprising and has grown her business significantly by migrating to electronic and educational toys and games and building sales outlets in different countries. Her growing toy shop needs a lot more investment. Tina’s Toy Shop raises money by issuing shares (equity) and using debt (bonds). The total value of Tina’s Toy Shop, assessed by the investors, is called the enterprise value (EV). Investors in Tina’s Toy Shop want a return on their investment just like the bank-charged interest. It makes sense that the return expected ought to be proportional to the enterprise value, because if Tina’s Toy Shop grew in enterprise value, the investors would like a proportional share or return. The proportional return is expressed by a term called the weighted average cost of capital (W). This is the cost to Tina’s Toy Shop of borrowing money. This cost is a weighted sum of the return rate expected by equity shareholders and interest payments to debt holders, respectively. Following this logic, the return expected by investors is the enterprise value multiplied by the weighted average cost of capital, denoted as EV x W. This is similar in form to the interest the bank charged on the loan it gave Tina’s Toy Shop to get it started.
Free cash flow to the firm (FCFF) is the cash generated in a period from all the sales of toys at Tina’s Toy Shop after subtracting the cost to make the toys, operating expenses (employee salaries, shop rents, utility bills, advertisements, etc.), taxes, and relevant investments (buying equipment for its toy-making factory). This resultant free cash flow is available to the company to pay interest on its debt, pay dividends to shareholders, and add to its cash balance, which can be used to invest in new initiatives. Thus, the FCFF represents the net return on investment by the toy shop.
In this example, EV x W is the expected return investors want for their investment in the toy shop, and FCFF is the actual return the toy shop generates, which is a measure of its financial performance.
Therefore, the Golden Rule, which offers a key standard to a business leader, is to make sure that the free cash flow to the firm, or FCFF, exceeds EV x W. Simply put, a company must generate more free cash than the return investors expect on their investment. This is a well-known formula in finance, and the one I use to assess if my business is financially fit.
This rule applies to most companies in the market. There are exceptions to this rule, such as numerous start-ups whose valuation and success have not depended on free cash flow but on eventual value creation. But at some point, these companies must meet the Golden Rule to continue to be valuable, unless they get acquired.
This Golden Rule has been on the top of my mind ever since an executive of the Ericsson Mobile Platforms (EMP) board asked me point blank, “Why should I continue to invest in EMP?” He continued by saying, “If I invest the same money in corporate bonds, I will get a 7 per cent return on my money each year rather than losing money every year, as I do by investing in your business. Please tell me you are sitting on a diamond mine and that it is just a matter of time before you will justify my investment and patience.”
Excerpted with permission from Your Company Is Your Castle: How to Build a Successful Company, Sandeep Chennakeshu, Aleph Book Company.
