The free-cash secret

What makes a company compound its free cash flows exponentially

- SAURABH MUKHERJEA

Free cash flow (FCF) is calculated as the difference between operating profits generated by a company for the year and the amount reinvested back into the business through: (a) investments in working capital; and (b) investments in fixed and intangible assets. Every firm typically goes through four stages in its lifecycle: nascent, growth, maturity and decline see chart 'Free-cash-flow lifecycle of a typical company'. The interplay of key determinants of FCF, i.e., operating profits, reinvestments and thus the quantum of FCF generation is significantly influenced by the stage of a company's lifecycle as shown in the chart.

While FCF is generally non-existent during the nascent phase (due to a lack of operating profits and heavy reinvestment needs), it starts building up as the operating profits start growing (growth phase). Then, after an inflection point when operating profits become sizeable enough to more than meet the reinvestment needs, there is an onset of the exponential FCF compounding phase.

While from this chart, it may seem a natural progression for every company to move up the free-cash-flow curve, in reality only a small subset of the companies at the beginning of each phase, irrespective of the longevity of their operations, graduates to the next higher phase of the free-cash-flow cycle. In fact, a large number of companies which have had operations for years or even decades are unable to generate operating profits and generate positive free cash flows due to a variety of reasons, including the lack of competitive advantages. At the same time, we have seen several instances of companies which are able to grow operating profits but continue to find FCF elusive. Such companies are typically in capital-intensive, low-margin sectors. In such companies, the high reinvestment in capex and working-capital days is a must for growth and these continue eating away at operating profits, resulting in low or no FCF.