How to work out a company's cash profit
What's the best measure of how well a company is doing? Should you look at its profits or cash flow?
The right answer is that you probably have to look at both.
Over the years more investors have slowly woken up to the fact that a company's profits and cash flow are not the same number. Cash is the lifeblood of any company. Companies that fail to produce sufficient cash flow are rightly treated with suspicion and can be very bad investments. Conversely, companies that generate shed loads of cash are highly sought after.
This has led to a big emphasis on analysing free cash flow (the amount of cash left over to pay to shareholders) by professional investors. This is a sensible thing to do and can be done very quickly in SharePad (click here to see how).
However, that doesn't mean that you should ignore a company's profit numbers. Free cash flow numbers are very useful because they tell you how much money is left over after tax, interest and new assets (capital expenditure or capex) have been paid for. But free cash flow does not tell you what a company's cash profits are.
In this article I am going to show you the difference between profits, free cash flow and cash profits and what they mean when you are analysing a company.
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The difference between profits and cash flow
Profits and cash flow are rarely the same in any given year. There's lots of reasons for this, but it mainly boils down to the fact that when companies choose to recognise income and costs, it doesn't mean that cash has been received and spent at the same time.
Most of the time there's nothing bad going on because of this. It is a fact of business life that companies buy and sell things on credit, make big investments in assets that will last for years or build up stocks of goods to sell later. This will cause the amount of cash flow coming in and out of the business to fluctuate from year to year.
What profit tries to do is to smooth out these lumps and bumps in cash flow and match costs with income each year. So, even though a customer hasn't paid for a product, it is still recorded as a sale when it is delivered to them.
It also means that the cost of a new machine is spread over its useful life (by charging depreciation against revenues) rather than expensing the entire amount spent in one year. Sometimes customers pay for goods and services in advance which brings cash in and businesses pay for materials before they are delivered which takes cash out. Building up stocks of goods reduces cash but the cost of doing so is only recorded in the income statement when they are sold.
All this matching of costs and income makes sense to me but is open to abuse. Companies can overstate their sales and understate their costs if they want to. That's why there is such a big focus on free cash flow to see if something dodgy is going on.
The problem with free cash flow
However, it hardly seems fair to penalise a company for selling goods on credit (increasing debtors) and making investments for the future (increasing stocks and capex) both of which reduce free cash flow. Nor does it seem right to reward a company for the fact that a customer has paid them (a prepayment) in advance or that they have delayed paying some of their bills (an increase in trade creditors).
Yet this is what free cash flow can do. If investors are unwary they can think that free cash flow is the true cash profit of the business. It might not be. It just shows you what's left over after all the flows of cash around the business have taken place which isn't necessarily the same as cash profits.
Warren Buffett and owner earnings
Warren Buffett has been looking at working out the cash profits of a business for many years. In his 1986 letter to shareholders (click here to read this. It's right at the end of the report) he described how he worked out what he called the "owner earnings" of a business. He did this because he believed the reported profits were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.
Owner earnings are calculated as follows:
Net income + depreciation & amortisation + other non cash items
- maintenance capital expenditure (stay in business capex)
Buffett's view then was that the amount of money a company needed to spend to maintain its competitive position (known as maintenance capital expenditure or stay in business capex) often exceeded the depreciation and amortisation expense and therefore profits were overstated.
Also if a business needed extra working capital (more stocks or more generous credit terms to customers) then this should be added to the maintenance capex figure. Generally speaking, though, this calculation ignores changes in working capital that are included in free cash flow.
Estimating stay in business capex
All this is all very fine in theory. But how on earth does a company outsider and investor work out how much money a business needs to spend to remain competitive?
The truth is they can't. Companies don't tend to give a breakdown between money spent on maintaining assets and the proportion spent on growing the business.
Instead you are left with two practical alternatives of estimating this number.
- Slightly more than the annual depreciation and amortisation charge. This takes into account that this figure may be based on old values that are out of date. By multiplying it by 120% (or 1.2) you make some allowance for this and the possibility of some extra working capital being needed.
- Just take away the total amount of money spent on capital expenditure for the year. If you want to be very conservative then use this figure. If capex is less than depreciation then use the depreciation expense as a minimum figure.
- A third alternative is to take an average of the last five years' capex and use that figure. This will work if there have not been big variations in the amount of money spent.
You will not get a true figure of owner earnings but as Buffett said in relation to this issue, he'd rather be "vaguely right than precisely wrong".
Calculating owner earnings for Tesco
We are going to look at net income, free cash flow and owner earnings for supermarket company Tesco in 2014 - the year before its profits completely collapsed. Comparing these three numbers is a very useful exercise. Ideally you should do this over a number of years to see if there is any trend.
| Tesco 2014 (£m) | OE1 | OE2 | FCF |
|---|---|---|---|
| Normalised net income | 2391 | 2391 | 2391 |
| Dep & Am | 1532 | 1532 | |
| 120% of Dep & Am | -1838.4 | 0 | |
| Total capex | 0 | -2881 | |
| Owner Earnings/FCF | 2021.6 | 979 | 487 |
| as % of Norm Earnings | 84.55% | 40.95% | 20.92% |
I've calculated two measures of owner earnings. OE1 which estimates maintenance capex as 120% of depreciation and OE2 which deducts the total amount of capital expenditure. The free cash flow figure is taken from SharePad.
What you can see is that OE1 is not significantly different from reported net income based on the guess of maintenance capex being 120% of depreciation and amortisation. However, what is startling is the big differences when OE2 and free cash flow are used both of which are calculated using the total amount of capex.
This is a red flag and needs investigating. As well as comparing capex with depreciation you should also look at the operating cash flow figure and compare the interest and tax charges in the income statement with those in the cash flow statement.
Could it be that Tesco's high levels of capex were needed just to remain competitive and that its profits were overstated? When Warren Buffett invested in Tesco it is quite possible that he underestimated the amount of stay in business capex - in a big way. Hindsight is a wonderful thing but Tesco's high capex spending had been going on for years only for its profits to collapse later on.
Reckitt Benckiser - a much better cash generator
In stark contrast to Tesco, Reckitt Benckiser's owner earnings and free cash flow compare very favourably with its reported profits.
| Reckitt Benckiser 2014 (£m) | OE1 | OE2 | FCF |
|---|---|---|---|
| Normalised net income | 1684 | 1684 | 1684 |
| Dep & Am | 177 | 177 | |
| 120% of Dep & Am | -212.4 | 0 | |
| Total capex | 0 | -184 | |
| Owner Earnings/FCF | 1648.6 | 1677 | 2379 |
| as % of Norm Earnings | 97.90% | 99.58% | 141.27% |
Again, you need to do this exercise for several years to see if there is a consistent trend or whether capex is artificially high or low.
Owner earnings isn't a perfect calculation by any means. However, used in conjunction with other measures it can be a handy addition to your investing toolbox.
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