Two friends meet over lunch. One is an investment banker and the other is a software developer, who also happens to be newbie investor. They start discussing about recent the earnings season.

Yash: Did you check the Q4 results of Tata Steel? I read that its consolidated net profit rose by 37 per cent YoY, and it has met the estimates. This firm has been posting good numbers consistently. Now, I am feeling relieved that I have invested my hard-earned money in a firm which can provide me with good returns over time.

Nishith: Yes, the results were good.  But just asking generally, do you make an opinion on a firm’s financial strength solely based on its net profit?

Yash: Ya, why can’t we say that? Haven’t we heard that profit is the ultimate king?

Nishith: Have you heard about Free Cash Flow (FCF) by any chance?

Yash: No, I’ve never heard anything about FCF. What is that?

Nishith: Do you remember you owing someone money or someone owing you?

Yash: Yes, I owe Pranav ₹2 lakh for a car I have purchased from him. Raj owes me ₹50,000 for the bike I sold to him as I did not need it after I got the car. We plan to settle the payments over the next month.

Nishith: Companies are also involved in such stuff but in a bit systematic manner. Net profit is the result of the difference between the income and expenses of a company based on concept of accrual accounting. That is whether, cash has moved for the transaction or not, the incomes and expenses are booked as they pertain to that period. Thus, a company will book revenue and that may add to net profit, even if the cash is likely to be received later from the customer.  Same concept for expenses. Now what happens if the customer does not pay the company? Although you have booked revenue/profits from the sale, it is of no use.

Hence looking at net profit along with cash flows is a better way to analyse results.  FCF is the real cash that any firm earns in a year. It is that cash which a company generates after receiving and spending cash from company’s daily operations and after paying for capital expenditure that are required to sustain or grow its business. FCF is equal to cash from operations minus capital expenditure.

Yash: So, it means that even if a firm has a good net profit it doesn’t mean that the firm can spend anything or give dividends if it doesn’t have a strong cash position. Right?

Nishith: Yes, you are right.

Yash: But I can see that both FCF and Net Profit are rising and share the same pattern for Tata Steel

Nishith: Correct, both have shared similar pattern over the years but this may not be the same for all companies and you must check for that while investing. Have you heard about a US firm called Home Depot?

Yash: Yes, its involved in the business of home improvement products

Nishith: Correct. Home Depot faced a cash crisis during 1980’s. It had a stable net profit, but a growing deficit of FCF, as the pace at which the capital expenditure was incurred on business expansion was much more than the pace of cash being received.

Yash: So, you mean whenever there is positive net profit and negative FCF, the firm is in trouble, right?

Nishith: No. That’s not what I meant. Let me give you an example of our favorite binge-watching platform Netflix. Netflix had this same situation during 2015-19. It had any increasing net profit but a stream of negative FCF. They were using their FCF deficit to cater to the likings of more and more variety of customers they were getting. They were spending a lot of cash on production and licensing costs to have a variety of content on its platform which ultimately reaped, and the firm finally started having positive and growing FCF since 2020.

Yash: So, as I see it, FCF is that cash with which the firm is free to do anything like repaying to creditors and paying dividend to shareholders. It is a powerful metric because it has the capacity to reveal problems in any firm before they are actually noticed at the net profit level. Also, do bear in mind decreasing/negative FCF doesn’t always mean bad for a firm as many a times negative FCF due to spending more on capex may reap benefits for a firm in future. But you must check how the FCF is faring, whether the company debt is manageable while FCF is negative, and whether the capex will pay off in the long run.

Nishith: There you go! You have just explained it perfectly. Thanks.