Why Free Cash Flow is the Secret Sauce to Business Growth (and How You Can Leverage It)?

Picture this.

You’ve just finished college, and you’ve got your first job. Life is new, exciting, and, of course, expensive.

Now, let’s say you’re living in a small apartment, keeping things simple. Every month you get a paycheck, and by the time you’ve paid your rent, groceries, electricity, and maybe grabbed a drink on weekends, you notice something: what’s left at the end of the month, if anything, feels like gold. Isn’t it?

That leftover cash is what you’ve truly earned (or saved), something you can either save for a rainy day, invest in the stock market or invest in making your life better.

In the world of business, we call this “Excess” cash left with you after paying all expenses – Free Cash Flow (FCF). It’s what makes the difference between just getting by, borrowing from your friends/family – and thriving.

What is Free Cash Flow?

Alright, let’s dive deeper into Free Cash Flow (FCF) but keep it simple. Think of FCF as what a company has left in its pocket after doing everything it needs to keep running. After all, a business has bills to pay, just like you do.

Here’s the formula for Free Cash Flow, but don’t worry, we’ll break it down piece by piece:

FCF = CFO – Capex – Debt Repayment (interest + principal)

Let’s break this formula into its main components: CFO (Cash from Operations), Capex (Capital Expenditures), and Debt Repayment (interest + principal).

I. Cash from Operations (CFO): The Starting Point

Cash from Operations is where it all begins. This is the cash a company generates from its everyday business activities – selling products, providing services, whatever it is they do to keep the lights on and the employees paid. It’s like the paycheck you get from your job – the money you earn before thinking about rent, food, or utilities.

A company’s CFO tells you how much cash it brings in through its core business. It doesn’t include one-time gains (like selling an old office building) or investment income. CFO focuses on the here and now – what the business does day-to-day.

Think of CFO as the oxygen supply of the business. If it’s low or negative, the company will struggle to breathe, no matter how good it looks on paper. A company can report solid profits on its income statement, but if it’s not turning those profits into actual cash, that’s a problem.

Remember: Cash flow is what keeps the business alive.

II. Capital Expenditure (Capex): Keeping the Machine Running

Now, what about Capex? This is the money a company spends to maintain or grow its operations. Think of it like home maintenance – fixing a leaky roof, upgrading your kitchen, or even adding a new room. It’s necessary spending if you want your home (or business) to remain valuable and functional.

For a company, Capex can include things like buying new machinery, upgrading technology, or building a new factory. While this spending is critical for growth, it also eats into the company’s cash reserves.

A company with a heavy Capex requirement might find itself with less Free Cash Flow because it’s constantly reinvesting in its operations. But that’s not always a bad thing – it depends on whether the investments are wise and generate future returns. For example, a tech company might need to spend a lot upfront to develop cutting-edge software, but if that investment pays off, the future Free Cash Flow will increase significantly.

However, if Capex becomes too high or isn’t leading to higher returns, it can start to hurt the company’s financial health. It’s like spending too much on home renovations without increasing the value of your property.

III. Debt Repayment (Interest + Principal): Paying Off the Loan

Finally, let’s talk about Debt Repayment. Every business, like individuals, can borrow money to fund growth or keep things running smoothly during tough times. But debt doesn’t disappear – it has to be repaid. This includes both the principal (the actual loan amount) and the interest (the cost of borrowing the money).

Debt repayment is crucial because it reflects how much of a company’s cash is being used to pay back what it owes. The more debt a company has, the more it will need to allocate from its Free Cash Flow to cover those obligations. Paying off debt reduces the risk of financial trouble in the future and strengthens the company’s balance sheet.

What does this mean for us as shareholders? When a company pays off its debt, it lowers its interest payments, which means there’s more cash available for other uses – like increasing earnings per share (EPS), retaining cash for growth, or paying out higher dividends to shareholders. Essentially, reducing debt improves the company’s overall financial health and flexibility.

Pulling It All Together: Why FCF Matters

Now that we’ve unpacked the components of Free Cash Flow (FCF), let’s look at why it’s such a big deal—especially for shareholders. FCF isn’t just about keeping the lights on. It’s about value creation, and that’s what really matters for investors. You see, after a company has paid for everything it needs—running its operations, maintaining and upgrading assets, and repaying debt—whatever cash is left is free. This cash can be used in ways that directly benefit shareholders.

Here’s how:

Dividends: Companies that generate healthy Free Cash Flow often use a portion of it to pay dividends. Dividends are a direct return on investment for shareholders. If a company can consistently pay and increase its dividends over time, it’s a sign that it has strong, reliable cash flows. Investors love this because it provides them with steady income, and over time, dividend-paying stocks tend to outperform those that don’t.
Share Buybacks: Another way companies reward shareholders is by buying back their own stock. When a company has excess FCF, it might repurchase shares from the market. This reduces the number of shares outstanding, which increases earnings per share (EPS) for the remaining shareholders. Share buybacks are a powerful way to create value because they not only signal confidence from the management team but also improve key financial metrics.
Reinvestment for Growth: FCF also gives a company the flexibility to invest in future growth. Whether that’s launching new products, expanding into new markets, or acquiring other businesses, reinvesting FCF can generate higher returns down the line. And as the company grows, so does the potential for the stock price to rise, which directly increases shareholder value.
Debt Reduction: We’ve already talked about debt repayment, but here’s why it matters to shareholders: when a company reduces its debt, it frees up future cash flows. Less debt means lower interest payments, which means more cash can flow back to shareholders through dividends or buybacks, or be reinvested into the business. A debt-free or low-debt company is also seen as less risky by investors, which can boost its stock price.
Increased Valuation: Free Cash Flow is often seen as a true measure of a company’s profitability because it strips away non-cash items like depreciation and focuses on real cash generation. Investors use FCF to gauge how much value a company is truly creating. If a company can consistently grow its FCF, it’s seen as being in control of its financial destiny. This often leads to higher valuations in the market because investors are willing to pay more for businesses that generate real, tangible cash.

For shareholders, FCF is the key to long-term value creation. It’s not enough for a company to be profitable on paper; it needs to be generating cash that it can use to reward its investors. Free Cash Flow is the ultimate sign that a company is healthy, efficient, and primed for growth. As an investor, understanding FCF helps you see beyond the earnings reports and into the heart of the company’s ability to create value—today and in the future.

Let’s take a few case studies to understand Free Cash Flows better, shall we?

Free Cash Flow: Why One Company is Better Than Another

Let’s dig deeper into the difference between two companies—both growing their revenues at the same rate but one requiring much more Capital Expenditure (Capex) than the other. And both of them belong to the same industry.

And listen, this is where Dhandho principles come into play— how a company goes about maximizing returns while minimizing risk.

If you’re familiar with dhandho investing, you know it’s about finding businesses that offer the highest return on capital with the least amount of investment and risk. And Capex plays a massive role in this calculation.

Those who haven’t read the legendary investor, Mohnish Pabrai’s Dhandho Investor should better read it now. (Amazon Link)

And hello, we just learnt that this capex in turn has an impact on the free cash flows of the company. Doesn’t it? Let’s take an example just to drive home the point.

Example: Company A vs. Company B

Let’s say we have Company A and Company B. Both companies belong to the auto ancillary industry and are growing their revenues at the same rate—let’s assume a 10% annual growth rate. But their Capex requirements differ significantly.

Company A needs to invest heavily to maintain its growth. It spends ₹500 crores in Capex every year.
Company B, however, has lower Capex needs and only spends ₹200 crores annually.

Both companies have identical Cash from Operations (CFO) of ₹1,000 crores. Now let’s see how this difference in Capex affects their Free Cash Flow (FCF):

Company A’s FCF:

CFO: ₹1,000 crores
Capex: ₹500 crores
Debt Repayment: Let’s say ₹100 crores (interest + principal)

So, the Free Cash Flow for Company A would be:

FCF = CFO – Capex – Debt Repayment
FCF = ₹1,000 crores – ₹500 crores – ₹100 crores
FCF = ₹400 crores

Company B’s FCF:

CFO: ₹1,000 crores
Capex: ₹200 crores
Debt Repayment: ₹100 crores (same as Company A)

Now, let’s calculate the Free Cash Flow for Company B:

FCF = CFO – Capex – Debt Repayment
FCF = ₹1,000 crores – ₹200 crores – ₹100 crores
FCF = ₹700 crores

Why Company B Is Better from a Dhandho Perspective?

Here’s where dhandho principles help us figure out why Company B might be the better investment:

Higher Free Cash Flow: Despite both companies generating the same amount of cash from operations (₹1,000 crores), Company B has ₹300 crores more Free Cash Flow because it doesn’t need to spend as much on Capex to maintain its growth. That’s a massive difference. More FCF means Company B has more flexibility to reinvest in growth, pay dividends, reduce debt, or repurchase shares.
Efficient Capital Allocation: In dhandho investing, you want to look for companies that require less capital to generate high returns. Company B is more efficient because it’s generating the same revenue growth as Company A, but with significantly lower Capex. This is critical during market downturns or when interest rates rise—Company B has the buffer to keep growing without having to scramble for more funding or cut expenses.
Risk Management: Companies with heavy Capex requirements are riskier during bad economic times. If the market slows down, and revenue drops, Company A will still need to keep spending heavily to maintain its infrastructure. That could lead to cash flow issues or the need to raise more debt. Company B, with its lower Capex, is better positioned to handle a downturn, making it a lower-risk investment.
Debt Repayment and Value Creation: Both companies are repaying debt, but since Company B has more Free Cash Flow, it can more aggressively reduce its debt or use the extra cash for shareholder returns, increasing value creation. Over time, Company B will likely boost its EPS faster, reward shareholders with dividends or buybacks, and reinvest in growth without the strain of heavy spending.

What Happens in a Market Downturn?

In a market downturn, the importance of Free Cash Flow becomes even more apparent. Let’s assume both companies face a revenue dip due to external factors. Revenues for both Company A and Company B drop by 10%. Now, Company A has to keep spending that ₹500 crores on Capex just to maintain its current infrastructure and business. With a drop in CFO due to the revenue decline, Company A may see its Free Cash Flow shrink drastically, or worse, go negative.

Company A in a downturn:

CFO: ₹900 crores
Capex: ₹500 crores (still necessary)
Debt Repayment: ₹100 crores

FCF = ₹900 crores – ₹500 crores – ₹100 crores = ₹300 crores

But what if Company A faces an unexpected expense or its CFO declines further? If the company needs to maintain its ₹500 crores Capex spending and debt repayments, it could easily end up with negative FCF:

–CFO: ₹600 crores
–Capex: ₹500 crores
–Debt Repayment: ₹100 crores

FCF = ₹600 crores – ₹500 crores – ₹100 crores = ₹0 crores

FCF if CFO drops further by 100 crores = -₹100 crores

Now Company A is running a negative cash flow. This scenario forces the company to either borrow more, cut down on future growth investments, or even risk its financial stability. In contrast, Company B remains more resilient in such times.

Meanwhile, Company B can better handle the revenue drop because of its lower Capex needs:

Company B in a downturn:

CFO: ₹900 crores
Capex: ₹200 crores
Debt Repayment: ₹100 crores

FCF = ₹900 crores – ₹200 crores – ₹100 crores = ₹600 crores

In tough times, Company B maintains a much stronger cash position. This gives it the flexibility to survive, even thrive, while Company A may need to take on more debt or cut back on growth investments. This is exactly the kind of scenario that dhandho investors seek to avoid – companies with high capital requirements and low cash flexibility.

Capex and Shareholder Value Creation

In the long run, Free Cash Flow is one of the key metrics driving shareholder value. Here’s why:

Company A may continue growing but will always be reliant on heavy Capex to maintain that growth. This eats into its ability to generate excess cash for shareholders.
Company B, however, with lower Capex, has more cash available to reinvest, repay debt, or return to shareholders. Over time, this makes Company B a better candidate for value creation – higher dividends, potential for share buybacks, and stronger EPS growth.

From a Dhandho investing perspective, Company B is maximizing its return on invested capital while minimizing risk, making it the smarter bet. [Return on Invested Capital is a very crucial topic which we plan to cover too in the upcoming post.]

Are All Negative FCF Companies Bad?

At first glance, seeing negative Free Cash Flow (FCF) might make investors nervous. It’s like running a household where expenses keep exceeding income—on paper, it looks worrisome. But not all negative FCF companies are in trouble, especially if they’re on a growth trajectory. Let’s dive into this idea by examining a real-world example: Ethos, a leading luxury watch retailer in India.

Ethos: A Negative FCF Story, but Not a Bad One

Ethos is expanding its footprint in India, capitalizing on the growing demand for premium and luxury watches. It’s building more stores, expanding its inventory, and aggressively marketing to capture market share. But all of this comes at a cost, and currently, Ethos is generating negative Free Cash Flow.

Let’s break this down:

High Cash from Operations (CFO): Ethos is generating significant cash through its daily operations—selling watches, growing revenues, and expanding its brand presence in the last 5 years except for FY23.
Massive Capex Needs: But with growth comes the need for large capital investments—new stores, showrooms, brand tie-ups, and expanding inventory to cater to a larger customer base. All of this requires substantial spending on Capex.
No Major Debt Repayment: Majorly the repayment made by Ethos every year is lease payment / lease principal repayment only. This is what we have considered in our above calculations as well.

The Management is focused on growth at this stage believing that the upcoming period could be a huge opportunity for the company. They are confident that once this leg of aggressive growth capex is complete, they won’t be needing external capital to thrive:

Thus, this negative FCF might look alarming at first glance. Ethos is spending more than it’s making, but it’s doing so with a long-term goal in mind—building dominance in the luxury watch market. The negative cash flow is a direct result of the company’s aggressive growth strategy. It’s like a young person taking out student loans to build their education foundation, knowing it will pay off in the future.

In certain industries, like retail, companies often have negative FCF while they scale up. This is especially true for companies like Ethos, where inventory and physical presence are crucial to growth. Here’s why negative FCF isn’t always a red flag:

Expansion Costs Today, Profits Tomorrow: For a company like Ethos, the negative FCF is due to high Capex spending to open new stores and stock luxury inventory. But this is not a waste—it’s an investment in future growth. Once these stores are up and running, Ethos will generate higher revenues and hopefully stronger cash flows, leading to positive FCF in the future.
CFO Is Strong: Even though the company is generating negative FCF, its Cash from Operations (CFO) remains robust. Ethos isn’t losing money from its core business operations; it’s just reinvesting that cash into growth initiatives. A strong CFO is a good sign that the company’s fundamental business is healthy.
Retail Industry Dynamics: Retailers like Ethos often have to front-load expenses. They need to buy inventory upfront, pay for store expansions, and market their brand. This leads to temporary negative FCF, but once sales pick up and the new stores become profitable, FCF improves. Retailers frequently face this kind of cycle in their early or aggressive growth phases.
Debt Repayment Can Wait: Companies like Ethos often delay large-scale debt repayments in their growth phase. Why? Because paying down debt now, when they can use the cash for expansion, doesn’t align with their growth strategy. They can handle debt later when they’re generating more cash and have a stronger market position.

Examples of When Negative FCF Is Bad

Of course, not all companies with negative FCF are in a good position. Imagine a situation where:

The company’s CFO is declining, meaning the core business isn’t generating enough cash to support operations.
Capex continues to rise, but it’s unclear how these investments will lead to future growth.
Debt keeps piling up, but the company has no clear path to repay it or manage the interest costs.

This situation is a red flag, especially in industries where Capex isn’t essential for future growth, or where the company’s core operations are weak.

The Case for Ethos and Similar Growth Companies

In Ethos’ case, the negative FCF is not a sign of financial distress but rather a reflection of its aggressive growth strategy. The company’s goal is to dominate the luxury watch space in India, and that requires heavy investments today for bigger returns tomorrow.

As investors, we need to keep this in mind when analyzing companies with negative FCF. Growth companies like Ethos, particularly in retail or tech, can have negative cash flows for years before they turn the corner and become highly profitable. It’s about understanding why the FCF is negative—is the company reinvesting in its future, or is it simply burning cash without a clear path to profitability?

In the case of Ethos, the answer seems clear: it’s laying the groundwork for a strong future, making the current negative FCF a necessary part of its growth story.

Balance Sheets and Cash Flow Statements: Your New Best Friends

So how do we know whether a company’s Free Cash Flow is solid? The answer lies in its balance sheet and cash flow statement. The balance sheet tells you what the company owns and owes, giving you a snapshot of its financial health. The cash flow statement, on the other hand, is where you’ll find the real action – it shows you how much cash is coming in from operations, how much is being invested, and what’s being used to pay off debt.

Together, these two statements help you understand how well a company is managing its resources. Free Cash Flow, pulled from these two documents, becomes a mega-metric. It’s the heartbeat of the business. It tells you how much cash is truly free for the company to grow, repay debt, or reward shareholders.

Conclusion

Free Cash Flow is more than just a number. It’s the lifeblood of a company, revealing whether it’s standing tall after all its obligations or scrambling to make ends meet. As investors, we want to see a company that’s efficient in generating and using its cash. It’s not just about growing sales or profits; it’s about what’s left after the dust settles. When you know how to look for Free Cash Flow, you’re not just looking at the surface – you’re getting to the heart of a company’s financial strength, its survival instincts, and its potential to thrive.

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