The net flow of cash into and out of a business is to my mind the most vital measure of the success or otherwise of that business, captured in the cash flow statement.
The P&L, and Balance sheet, vital as they are as performance measures, can be susceptible to ‘management’. The flow of cash is less able to be similarly ‘managed’
It is however, like all numbers, subject to the context.
Free cash flow is the cash generated by a business less its Capital expenditure.
The summary formula is: Net operating cash flow – Capital Expenditure. (Capex)
It is a very simple calculation once you have the cash flow statement in hand.
Free Cash Flow can vary dramatically over periods of time, so the trends are a vital part of the consideration. A business might invest a lot today in capital that is expected to deliver profits in the future, and should not be penalised for doing so, rather it should be supported, so long as the investments are sensible, which is another whole set of considerations. Every business needs to invest in the productivity of existing assets by way of renovation and replacement, as well as supporting innovation and maintaining regulatory compliance.
The trends in free cash flow and Capex expenditure are key measures of commercial sustainability.
I have seen businesses being tarted up for sale that display impressive increases in free cash flow over a few years, but as always, the numbers can lie. When you go behind them, the Capex has been restrained to the long term detriment of the business, to make it more attractive in the short term.
As an antidote to the rosy picture that can be generated by reducing Capex, I like to see the free cash flow and capital expenditure trends on the same sheet of paper, and being a marketer, as a graph. You can go one step further and break up the Capex into three categories:
Capex spent for regulatory and compliance reasons
Capex spent for productivity and capacity reasons
Capex spent on new products and processes.
The nature of the Capex can tell you a lot about the health of the business, and its prospects.
Cartoon credit to Scott Adams and Dilbert.
Allen, These are exactly my thoughts on this important subject. Sadly most SME’s don’t do any of this. They often say “Looki at the profits I’m making but I don’t have any cash – how can that be?” Most projections don’t allow for debtors and inventory – major items soaking up cash.
Cash should be a focus for every business, especially an SME.
You can go broke succeeding when you look at a pro forma P&L monthly.