“Cash is king” is a common refrain in investing and investment analysis. Just because a company generates positive earnings doesn’t mean it will succeed. It still needs to generate cash to survive. A business that generates a significant amount of cash, all else equal, is considered to be the better business, as items such as salaries, rent and office expenses are paid from generated cash and not net income. Thus, whether a company can generate sufficient cash is what matters to stakeholders.
This poses an issue when we evaluate companies based solely on earnings. Net income is the “bottom line” of the income statement for a company. It is the net balance between income and expenses. However, income and expenses are reported irrespective of whether cash has been paid or received. Accrual accounting attempts to match revenues to expenses for a given accounting period, regardless of whether cash was received or used during the period.
One measure of cash flow for a company is free cash flow, which shows how much cash a company has for discretionary spending. Free cash flow is calculated by deducting capital expenditures (capex) from cash from operations.
Cash from operations tries to look into the cash inflows and outflows caused by the core business operations and, in turn, the cash generated by the company’s products and services. It reflects the changes made in cash, accounts receivables, inventory, depreciation and accounts payable segment.
Capex are funds used by a company to acquire, upgrade and maintain physical assets such as property, industrial buildings or equipment. Capex is often used by a firm to undertake new projects or make investments. This type of financial outlay is also made by companies in order to maintain or increase the scope of their operations.
What’s the purpose of deducting capex from cash from operations? Cash from operations offers an idea of how much cash a company’s day-to-day operations have generated. However, for a company to grow, it must also reinvest in itself to maintain operations as well as expand them. While skimping on capex is a way to save money in the short term, in the long run it is a surefire way to inhibit growth.
This definition of cash flow describes a pre-dividend free cash flow figure. The residual cash amount indicates whether a company is generating enough cash from its normal business operations to fund its capital expenditures and still have money available to pay a dividend, retire debt, buy back shares or make acquisitions.
Discretionary spending by a company is very similar to your own. When times are good and we have more cash, we are willing to spend it on nonessentials. The same goes for a company. Now let’s say market conditions worsen and a company faces challenging times. If the company has a cash flow deficit, it must consume cash on hand or obtain additional funding. To save money, or to preserve its cash, companies may cut back on discretionary spending. If things get bad enough, this could mean a reduction in or suspension of dividend payments. As a dividend investor, this is the last thing you want to see.
There are ways to evaluate the safety of a company’s dividend by examining its free cash flow relative to its dividend—its free-cash-flow payout ratio. It analyzes how much cash a company is paying in dividends as a percentage of free cash flow. It is an alternative measure of the more typical earnings payout ratio, which is the ratio of dividends per share to earnings per share. However, earnings can include unearned revenues or noncash items as a result of accrual accounting.
As an example, let’s examine DI holding Union Pacific. The company generated $7.23 billion in operating cash for fiscal 2017. It spent $3.24 billion in capital expenditures, leaving $3.99 billion in free cash for 2017. For that period, the company had average diluted shares outstanding of 801.7 million. Its free cash flow (pre-dividend) of $4.98 per share easily covers the $2.42 it paid in per-share dividends in 2017. The 2017 free-cash-flow payout ratio is 48.6% ($2.42 ÷ $4.98). The table here illustrates these calculations. Investors should look to the free-cash-flow payout ratio to understand if a company is generating enough cash (not earnings) to cover its dividends year to year.
Some definitions of free cash flow deduct dividends paid as well as capex from cash from operations. As dividend investors, we use a pre-dividend free cash flow measure to get an idea of the amount of cash a company has to pay the dividend to help judge whether the dividend is sustainable.
From the November 2018 AAII Dividend Investing newsletter.