Why cash and free cash flow are important to your business? (2024)

Why cash is king?

You might be a veteran in the stock market. You might be having a set of considerations and principles to look at companies. So what criterion do you use to analyze a company? It might be revenue growth, gross margins, operating margins, net margins, operating cash etc. you might also look at free cash flow and net cash, but do you place enough importance to these figures?

My concept is very simple, you do a business to make profits. According to me, profit is the cash you have in bank. Revenues, net profits and other metrics are fine, but they are on the books. Cash is something you have left after you’ve conducted your business. Just tell me, how much money were you able to make after conducting all the operations. I sell x amounts of products and I get y amounts of sales and I get z amounts of net profits. Out of my net profits, how much money was I able to convert into cash? That is the question that I ask and is pivotal for me. What people fail to understand is, a lot happens once you reach your bottom line, that is, net profits.

How does cash actually flow?

Why is free cash flow important? Once you have reached net profits, the first thing that is taken away from it is working capital. You purchased raw materials at credit, you made a good amount of inventory out of it and you sold them at credit. You need cash to manage these requirements of the business. Many businesses have huge balance sheets and infrastructure, but close down in a flash because they did not make enough cash to cover their working capital requirements. After taking out working capital requirements, what you have left is operating cash. This metric shows you the efficiency of your business. The efficiency by which you were able to convert your profits on books to actual cash. A metric commonly used to analyze this part of the business is EBIT/Operating cash. It should be ideally above 100%, which means that the business is efficient enough to convert all of its operating profits into cash.

Second, another pile of money would go into capex. Some people would assume that, this is a discretionary expenditure but it’s not. There are two kinds of capex, maintenance capex and growth capex. Maintenance capex is a mandatory capex, which has to be done to maintain your existing business or more precisely to maintain the existing assets of the business. Say, you are in the business of renting out real estate, where you have to spend a certain portion of cash every year to maintain your properties such as paint, repairs, cleaning, new installations etc. Growth capex in this case would be to buy more properties to increase your topline. A business needs to grow at a certain pace, for which investing cash into growth is essential. But let’s say that, you don’t grow at all by infusing cash into growth, but you grow organically. But, maintenance capex is mandatory, as you have to look after your assets to maintain the existing revenue. So, Another chunk that will go out of operating cash is your maintenance capex. After removing capex (maintenance capex in this case), what you are left with is “free cash flow”. Free cash flow is the cash that you have left after doing everything in the business. This is the money you can take to the bank. However, there are certain things that a business would like to do with this cash instead of keeping this cash idle. They usually use this cash to repurchase shares from the stock market, which reduces shares outstanding from the market and thereby increases per share EPS. Companies also use this cash to payback their shareholders by way of dividend. They can repay their debt. The companies can also use creativity to spend this cash. For example, Tencent uses a certain portion of its free cash flow to invest back into its business and the remaining cash is used to invest in listed securities to generate a superior ROIC vs returns on savings accounts. Same with Alibaba and Amazon.

Ability to generate free cash flow is the bloodline of a business. You will come across a lot of businesses which have a lot to say but cannot generate enough cash. Before you know, these businesses run out of cash and close down. They may have phenomenal revenues and net profits, but lets say they have working capital which is quite huge and the company does not have enough cash to fund it. What happens? they may raise debt or equity to bring in more cash, but in the long-run this doesn’t work. They have to figure out a way to stop burning cash to survive. A phenomenal company with great product, vision, management and growth prospects cannot survive if they have cash flow issues.

Ok, so if free cash flow is important, why should we consider net cash or cash and cash equivalents at bank? Cash and cash equivalents are hard cash and cash invested into financial instruments such as bank deposits and money market funds which can be readily converted to cash. This cash is something which gives you a life jacket when things go south. According to me the market (not just the stock market) has its own cleansing process. Market always enters into a bear phase to cleanse off fundamentally weak businesses. Many businesses boast in a bull market, but they fail to survive in a bear market. Guess what makes fundamentally sound businesses to survive these downturns, its cash. Consider Covid-19, many businesses which did not have enough cash did not survive. Imagine, due to the pandemic your products are not selling, you have a pile of inventory (which has a lot of cash strapped up) and you are obviously losing customers. What saves you in this mess is the cash you accumulated over the years in good times. You weather out these bad times and get back on your game in good times. I am not a blind fan of growth, I like businesses which can survive. LAST MAN STANDING !!!. This is what airlines like Emirates and Lufthansa did during Covid-19, when all international travels were banned. They burned cash to survive. They did not have enough customers to run their businesses profitably. They burned huge cash to stay afloat, and once the global economy recovered and international travel resumed, these companies were up and running. All the other smaller airlines, which did not have enough cash were eliminated.

Check out the collapse of SVB Bank to understand, how can cash bring down major businesses…

Last piece of advise from me. Value the stocks based on free cash flow and the amount of accumulated cash. This can give you a deep insight on how disciplined the business is. See how much cash is the stock trading on. There were many companies which were trading at ~80% cash during the post pandemic bear market, which was caused due to high inflation globally. In bear markets, this indicator can give you a good estimate of your loss floor. Many companies in a bear market trade below their liquidation value, even blue-chip companies. Cash will make a business survive, survival keeps it alive. Always remember, cash is and will always remain king!!!