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Why is Free Cash Flow Important in a Business?

Cash is the lifeblood of any business. Without cash to operate its daily operations, a firm may have to rely heavily on bank borrowings to sustain its business.

While net profit is an important figure to look at, the net profit of a company tells us nothing about the cash coming into the business. Businesses are usually done on credit and a company may book revenue even before the actual cash comes into its coffers.

The amount of cash that flows in or out of a company can be found out from its financial statements under the Statement of Cash Flow. The Statement of Cash Flow consists of three parts – Cash Flow from Operating Activities, Cash Flow from Investing Activities and Cash Flow from Financing Activities.

Cash Flow from Operations shows how much cash is generated from the day-to-day operations. This figure can then be used to deduct the “capital expenditure” (under “Acquisition of property, plant and equipment” of Cash Flow from Investing Activities) that the company undertakes. Capital expenditure is usually used by a company to acquire or upgrade physical assets such as machineries, furnishings, buildings, or equipment. The resulting figure, obtained by subtracting capital expenditure from Cash Flow from Operations, is called the “free cash flow”.

Free cash flow is essential in any business as it allows the company to reinvest the cash, make acquisitions, pay dividends, buy back shares, and pare down debt. Without any free cash flow, the business has to borrow money from banks, undertake private placements or issue rights to its shareholders to sustain its business.

Let’s take a look at two companies, Hyflux Ltd. (SGX: 600) and Ezion (SGX: 5ME) to illustrate the point. Hyflux is a water management and environmental solutions firm while Ezion is involved in the marine industry.

Since 2010, Hyflux has negative cash flow from operations and thus, has no free cash flow to speak of. Below is a summary of the situation:

  2010 2011 2012 2013
Cash Flow from Operating Activities (S$’ mil) -49.5 -56.1 -234 -422.4
Capital Expenditure  (S$’ mil) -28.1 -53.4 -39.3 -6.7
Free Cash Flow  (S$’ mil) -77.6 -109.5 -273.3 -429.1

Source: Company Annual Reports

Due to the negative free cash flow situation, the firm has to rely heavily on bank borrowings. As of 30 June 2014, it had a total debt of S$1.15 billion. Its net profit is 2013 was only S$44 million. Debt was more than 25 times its net profit.

Ezion, on the other hand, had cash flow from operating activities but had no free cash flow.

  2010 2011 2012 2013
Cash Flow from Operating Activities (US$’ mil) 44.5 34.5 93.7 155.5
Capital Expenditure  (US$’ mil) -115.8 -125.5 -604.6 -703.5
Free Cash Flow  (US$’ mil) -71.3 -91 -510.9 -548

Source: Company Annual Reports

Just like Hyflux, Ezion is relying on bank borrowings hugely. As of 30 June 2014, it had a total debt of US$1.41 billion. In 2013, it had earnings of US$160.4 million. This translates to a debt position of eight times its 2013 profits.

Relying on banks to sustain operations is never a good idea. Currently we are in a period of artificially low interest rate. The only direction the rates can go is up. When the interest rates rise, interest expenses will increase and companies that rely on bank borrowings will have to pay more as interest. Also, when an economic crisis hits, banks may tighten up and may ask for debts to be paid back faster than it matures. A heavy debt load has caused many businesses to go belly up.

Foolish Takeaway

Foolish investors should always focus on the cash flow statement and not only look at the profit and loss statement. The net profit of a business doesn’t tell anything about whether the business is solvent but the cash flow statement does. Learn more about investing through a FREE subscription to our weekly newsletter, Take Stock Singapore. Sign up here now. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.