Cash Flows

Cash flows are one of the most critical financial tools for evaluating the economic health of a company or individual. This concept reflects the movement of money into and out of an organization during a specific period. Its primary purpose is to provide information about liquidity and the ability to generate cash to meet operational, investment, and financial obligations.

Cash flow can be compared in personal finance to managing income and expenses, where the goal is to ensure that income is sufficient to cover expenses and allow for savings or future investments. It covers a defined period, which may be monthly, quarterly, semi-annual, or annual, depending on the analysis required.

1. Types of Cash Flows

1.1.    Operating Cash Flows (CFO)

These reflect cash generated or used by the primary business operations. They are a key indicator of a company’s ability to generate consistent income. Operating cash flows include:

• CAPEX and OPEX:
  • • CAPEX (Capital Expenditures): Investments in fixed assets such as machinery, buildings, and equipment. Although they involve an initial outlay, they can yield long-term benefits.
    • OPEX (Operating Expenses): Recurring costs like salaries, rent, and supplies necessary to run the business.
• Divestments: Selling fixed assets such as machinery or properties generates cash flows that can be reinvested.
• Asset Sales: Liquidity obtained from selling tangible or intangible assets.
• Changes in Marketable Securities and Equity: Adjustments related to short-term investments in stocks, bonds, or other financial instruments.
• Other Investment Activities: Include cash movements from licenses, royalties, or lease agreements.

1.2.    Investment Cash Flows (CFI)

This type of flow reflects activities related to purchasing, selling, or acquiring long-term assets and other investments. Key components include:

• Debt Changes: Can include issuing or repaying short- or long-term debts.
• Issuance or Buyback of Shares: Cash raised through issuing new shares or spent on repurchasing own shares.
• Dividends Paid: Cash distributed to shareholders.
• Other Financing Activities: Include any other movements related to financing, such as obtaining bank loans or credit lines.

1.3.    Financing Cash Flows (CFF)

Financial flows show changes in the company’s financing structure. These include:

• Foreign Exchange Adjustments: In international companies, this adjustment reflects the impact of currency fluctuations on operations.

How to Calculate Free Cash Flow (FCF)

Free Cash Flow (FCF) is an essential metric that measures the cash available after covering operating expenses and capital investments. It is calculated starting from EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) by making the following adjustments:

1. Subtract changes in Working Capital (WC).
2. Subtract capital expenditures (CAPEX).
3. Subtract interest and taxes.
4. Add non-cash charges, such as depreciation and amortization.

FCF = EBITDA +/− Changes in Working Capital (WC) – CAPEX – Interest – Taxes + Non-Cash Charges - SBC

Key Concepts:

• SBC (Stock-Based Compensation): Employee compensation through SBC, while not an expense per se for the company, is an expense for shareholders since it reduces the company's per-share value.
  • • Stock grants: Direct payment in shares.
    • Stock options: The right to purchase company shares at a predetermined price. This incentivizes employees to increase the company's value so that the stock price rises, maximizing the difference between their strike price and the market price, thus generating profits.
• EBITDA: Earnings before interest, taxes, depreciation, and amortization.
• Changes in Working Capital (WC): Variations in accounts receivable, inventories, and accounts payable.
• CAPEX: Investments in capital goods such as machinery and equipment.
• Non-Cash Charges: Accounting expenses that do not involve cash outflows, such as depreciation and amortization. These provide a more realistic view of how a company’s cash flow is growing.

Key Differences Between EBITDA and Cash Flow

Aspect	EBITDA	Cash Flow
Includes CapEx	No	Yes
Debt Impact	No (excludes interest payments)	Depends (includes interest in free cash flow)
Tax Impact	No	Adjusted for taxes paid
Working Capital Variations	No	Yes

 

Warning Signs When Analyzing EBITDA and Cash Flow

• High CapEx: Capital-intensive companies (e.g., energy, manufacturing) often experience lower EBITDA-to-cash flow conversion rates.
• Constant Increases in Working Capital: Rapid growth that drives significant increases in inventory or accounts receivable can consume cash flow.
• Mismatch Between EBITDA and Cash Flow: This could signal aggressive accounting practices or structural issues.