Hidden value in free cash generation

Opinion
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TO those that have understood the concept of free cash, they have been and are still reaping the benefits that come along with it.

In more than one instance I have heard employees asking, “Why salaries are always late, but we are working overtime and production is at its all-time high”.

I can direct their attention to the concept of free cash. My writing style is driven by my professional experiences. It puzzles me that cash is still not a standing agenda at meetings; to some it is delegated to be a credit-control function.

A business for the future needs a free cash agenda. Cash is not merely a finance function; every member of the company must wake up with this agenda daily.

What is free cash

Investopedia defines it as the cash a company generates after taking into consideration cash outflows that support its operations and maintain its capital assets.

In simple terms this is the cash that remains after doing expenses, working capital, tax payments, interest and general maintenance capex.

Why is it important

From the simple definition above, as a business, free cash clearly shows the cash that remains after doing the routine stuff to maintain the business.

This opens a decision-maker to endless possibilities on what to do with the cash.

If free cash is not a KPI, you are robbed of knowledge of whether you are even making any cash. Remember sales or profits do not automatically translate to free cash.

Businesses and entrepreneurs often ask themselves why they are not growing but they are selling daily. In my books, free cash means growth.

You can toil all year round, but only being able to pay expenses. A business that wants to position itself for growth must monitor its ability to make free cash.

Free cash the kingpin of growth

A business needs cash lying around, this is when you can separate boys from men and girls from women. Endless opportunities await those that have a strong ability to generate free cash. 

What you do with the free cash is important. It can be the start of a conglomerate or the end of a happy story.

Expansion capex is the main avenue to use the free cash and grow the balance sheet.

This is believed to be the key to how the likes of Innscor, and Delta grew in this market.

Whenever I read a set of published financials, I run to the expansion capex section, it is a pity at times one struggles to easily locate this critical salient feature. The more free cash you have, the more you can acquire new business, finance bigger projects so that you reduce dependency on expensive loans.

I put forward an argument that the reason some businesses are not having new products, leading in innovation or finding new uses for their product is that there is not enough free cash to be channelled towards this. 

Dairibord Zimbabwe just launched a new product “Baobab dairy fruit mix”, this can only be done if there is free cash.  Those that generate free cash are seen on how they play in the expansion space. If a business does not have enough free cash, you cry foul when interest rates are hiked.

Contrary to public opinion, certain players are not growing necessarily due to corruption, but they have the free cash to take advantage of good business expansion opportunities.

At times good opportunities avail themselves, but you have no cash or loan finance to take advantage of it quickly, that is when free cash comes into place.

For me, if a business is not engaged in some form of expansion, then that business has no future and I want no part in it.

Free cash enables dividend payments, if you analyse you will see those that bring about significant free cash pay dividends consistently and they are the investors' dream asset.

You cannot operate a company and not reward the owners of the company.

 I have learnt that the key to success as a senior business leader is to keep your shareholder happy by paying him a dividend.

We can debate that capital appreciation is the key reason to hold a stock, but I propose that dividends cannot be underestimated, especially to attract institutional investors.

In my simple mind, a business that struggles to pay dividends is broadly not particularly good at free cash generation and most likely they do not even track this key metric.

With free cash you can repay expensive borrowings and target cheaper capital or can reduce exposure to ensure the interest portion is in check for future free cash generation. Such companies' distress can reflect energies on free cash generation and how they deal with the debt burden. At least if I was the CFO, that's what I would do.

With free cash, buying back your own stock is another option, it can even ignite share price growth and dispose of them when a need arises.

Buybacks send a good signal into the market that the stock is undervalued, and that management has enough cash to cover future capital expenditure and interest payments, they boost the earnings per share for existing shareholders.

Share buybacks can signal that there are no lucrative investments that may boost shareholder value, so instead of making an investment mistake, management is giving back the funds to the shareholders.

I kid you not, free cash is the king maker, even in business valuations, more value is imputed to a business with superior free cash generation ability.

Further components of free cash

Working capital cannot be over amplified, lack of, or poor, management of this metric can be disastrous to the business’s ability to generate free cash.

This is more pronounced in a hyperinflationary economy; it can be the death of a business.

There is always a fight between departments where sales personnel will push sales at all costs with little to no regard to cash generation as they leave the cash part to credit control.

The fact that bonus payments based on sales targets with no correlation to collections makes it worse.

I have seen companies in dire state where they are overstocked, debtors are out of control and battling to keep foreign creditors.

This makes free cash generation a tough battle as you need the free cash.

Those participating on the auction market are alive to the working capital dilemma of cash tied on the auction which can take months to unlock a supplier payment, and further delays to unlock product delivery especially from offshore suppliers.

This has negative effects on free cash generation.

Tax payment is an effective way to manage free cash, one can play around with tax payments and our commissioner can be very reasonable at times such that you can stretch this as much as possible and leave room to build your free cash position.

I credit government on this one as they have not been too aggressive to levy interest and penalties on overdue payments or denied players payment plans, this is helping the private sector to develop free cash.

Interest is the other component that needs to be overseen well in the quest to free cash generation. 

Businesses can be overly borrowed such that most of the cash being generated is being swallowed in interest repayments, more so now with the interest rates more than 200%.

If the free cash analysis is done well, you can even identify overpriced loans which need to be cut back on or identify a need to borrow more if you are within a safe range that does not jeopardise the free cash generation ability.

Maintenance capex — all capital expenditure must not be massed into one basket.

We can be buying capital items but not seeing growth or expansion as the mix of the expenditure is just on maintenance.

This number identifies opportunities for obsolete equipment if you see that you keep spending more on maintenance.

Progressive leaders will step in and consider outsourcing or leasing certain equipment and disposal of non-core assets in a bid to improve our free cash generation.

I hope I have struck a chord in someone with this piece and let us create value for the shareholders or our businesses and achieve the free cash so that we pay ourselves and grow our businesses.

As chartered accountants through our Institute of Chartered Accountants in Zimbabwe (ICAZ), we are on a drive for a “future fit CA” who will deliver value to organisations and free cash generation is one such way we are contributing to the economic agenda of this country.

The key is where to look and the measures to unlock the free cash.

Makwara is a chartered accountant with both local and international experience in finance, accounting, auditing and business strategy and currently is working as the group financial manager of a local listed entity.

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