Cash Flow: One Thing You MUST Understand

In this issue, it’s my goal to explain the Difference Between Operating Cash Flow and Free Cash Flow, so sit back and enjoy!

The job of every company is to make money, and there is no money like cash.

For companies, it might not be physical cash, but it’s definitely actual money that can be accessed at any time as opposed to a guaranteed IOU such as accounts receivable. It is not surprising that some investors always look at cash flow.

You really can’t get away without looking at earnings, but cash flow can let you assign a quality to earnings. For those people who like to get to the rawest of information cash flow is available on the cash flow statement.

Also, looking at the income statement can give you an idea of the mix of earnings. Between the two of those you can cut through the accounting and get an idea of what the company is doing.

Cash flow is great for those companies with subscriptions or digital sales that have deferred revenue, because they receive the money upfront, but might not be able to report certain amounts for months.

If it is a 2-year subscription the company has to slowly recognize the revenue for 2 years, and at the end of it the cash is long gone but you are still recognizing some revenue.

All this exists because we refuse to stand by and accept that companies are not really comparable to one another on a standard scale. We need some method of comparison.

Operating Cash Flow

Operating cash flow is the money the company receives as part of its business operation. If you sell widgets, than the money the consumer gives you is cash from operations. If you sell chairs but decide to sell some office equipment as part of a downsizing, it would not be cash flow from operations.

That is a silly example. If you receive money from a credit facility or from investors getting preferred shares that is cash from financing or investing and not operations.

Operating cash flow is the purest inflow and outflow of cash in relation to actually doing business.

From a company health perspective, it is one of the most important measures, but it is most suitable to simpler companies without too much complexity. With more complex companies you need to look at a lot of other stuff. Cash flow is always useful despite being limited every now and then.

Consider the few times that operating cash flow would be limited. Companies with great sales, but are terrible at business.

Excessive CapEx on assets that might not have good returns, and similar items. Non-operating cash outflows are not included.

So an inefficient company with efficient operations would look good from operating cash flow, but it uses that incoming wealth poorly.

Always look at the balance sheet with operating cash flow, because a company with weak operations can leverage the balance sheet to explore new opportunities or expand existing business or create new efficiencies. Nothing can be looked at in a vacuum.

Free Cash Flow

This is an interesting measure of cash flow that tends to be a favorite of many. It is cash that is not earmarked for anything specific. Normal operating cash flow might bring in cash that is directed to more production, and even profits can be used for this.

Free cash flow is almost like true profit, but it includes things that are not profit at all.

Free cash flow includes things like asset sales, which makes it different from operating cash flow. It also subtracts capital expenditures. That is pretty important, because CapEx is not a regular expense.

The money is not gone. It is carried on the balance sheet as an asset.

The end goal is for the company to generate a return on the asset. Free cash flow is what is left after all is said and done. It is not uncommon for an aggressively expanding company to have negative free cash. That means they are dipping into reserve cash for CapEx.

If a company is building up free cash it can mean that organic expansion is slowing down. Free cash flow will build up cash on the balance sheet, which can be used to pay debt, dividends, or make acquisitions.

There is a lot of debate about what is superior organic vs. acquisitions. That is probably something that should be discussed later. The point is that free cash flow can give you some insight into the trajectory and strategy of the company. Great earnings, but negative free cash can be a sign of a lot of expansion.

Free cash flow is like the end all goal of companies. The point is to do so well that you make so much money that even after all the checks written to expand the business you still have a lot of cash. Cash is pretty much the most important thing, and free cash is the most flexible kind of cash there is.

The Bottom Line

Cash flow is a great way to judge the quality of the other numbers. Especially free cash flow, when you look at CapEx.

There are some companies doing so well that even after heavy expansion they have a lot of cash left over. It can be a great way to get a better understanding of companies, and head off issues.

Some companies expand aggressively in order to prevent a decline, and that can be a sign of weakness.

You can see the expansion and make a judgment on what you think will happen.

Cash flow gives you a really good picture of companies, and it remains well-known but underused.

The importance of cash means that even short-term traders can benefit from taking a look, but mid to long-term traders might find a bit more benefit.

Even short-term traders need to spot problems early for a potential trade later.


— Tim Sykes
Editor, Penny Stock Millionaires

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