Free Cash Flow and the Balance Sheet: Reading a Company's Financial Health

Free cash flow is the cash a company produces from its operations after paying for the investment needed to keep and grow the business: operating cash flow minus capital expenditure. The balance sheet shows what a company owns (assets), what it owes (liabilities) and what belongs to shareholders (equity) on a single date. Together they tell you whether reported profits are turning into real cash and whether the company could survive a bad year.

Why cash is not the same as profit

Accounting profit follows rules about when revenue and costs are recognised, not when cash moves. The main differences:

• Depreciation and amortisation: the cost of a machine bought years ago is spread over its life, reducing profit each year without any cash leaving now.
• Working capital: if customers pay late, revenue is booked but the cash sits in receivables; if the company builds up inventory, cash leaves before any sale.
• Stock-based compensation: a real cost to shareholders that uses no cash.
• Capital expenditure (capex): money spent on factories, equipment or data centres, which hits cash today but profit only slowly, through depreciation.

The cash flow statement

It has three parts:

1. Operating activities: cash from the business itself. It starts from net income and adds back non-cash items such as depreciation, then adjusts for working capital.
2. Investing activities: capex, acquisitions and purchases or sales of investments.
3. Financing activities: borrowing and repaying debt, issuing or buying back shares, and paying dividends.

Free cash flow

Free cash flow (FCF) = cash from operations - capital expenditure.

FCF is what pays dividends, funds buybacks, reduces debt and pays for acquisitions without borrowing. A company that reports profit but never produces free cash flow has to keep borrowing or issuing shares.

Negative FCF is not always bad. A fast-growing company may spend heavily on capex that will pay off later. The question is whether it can fund that spending safely and whether the investment has earned good returns in the past.

The balance sheet

Assets = liabilities + equity, always. Here is Northbridge's simplified balance sheet (millions of US dollars):

Assets		Liabilities and equity
Cash	1,500	Accounts payable	1,200
Receivables	1,800	Short-term debt	800
Inventory	1,400	Other current liabilities	1,000
Current assets	4,700	Current liabilities	3,000
Property, plant and equipment	6,000	Long-term debt	4,200
Goodwill and intangibles	3,300	Other liabilities	800
		Shareholders' equity	6,000
Total assets	14,000	Total liabilities and equity	14,000

"Current" means due or expected to turn into cash within a year. Goodwill arises when a company pays more for an acquisition than the book value of what it bought. If that acquisition disappoints, goodwill is written down (an impairment), which cuts profit and equity.

The ratios that matter

Ratio	Formula	Northbridge	What it tells you
Current ratio	Current assets / current liabilities	4,700 / 3,000 = 1.57	Cushion to pay bills due within a year
Net debt	Total debt - cash	5,000 - 1,500 = 3,500	Debt left after using all cash
Debt / equity	Total debt / equity	5,000 / 6,000 = 0.83	How much of the funding is borrowed
Net debt / EBITDA	Net debt / EBITDA	3,500 / 2,500 = 1.4x	Years of operating profit needed to repay debt
Interest coverage	Operating income / interest	2,000 / 200 = 10x	How easily profit covers interest
Return on equity (ROE)	Net income / equity	1,422 / 6,000 = 23.7%	Profit made on shareholders' money
Return on invested capital (ROIC)	After-tax operating profit / (debt + equity - cash)	1,580 / 9,500 = 16.6%	Profit made on all capital in the business

EBITDA here is operating income of $2,000 million plus $500 million of depreciation and amortisation. After-tax operating profit is $2,000 million x (1 - 21%) = $1,580 million.

ROE can be inflated by heavy borrowing, because debt shrinks equity. ROIC includes debt, which makes it the better measure of how good the business itself is. Companies that earn a high ROIC year after year are what investors usually mean by "quality" (see stock trading strategies).

The bad-year test

Levels that count as "safe" differ by industry: utilities with steady regulated income carry more debt than technology or retail businesses can.

A checklist for any company

1. Is FCF positive, and roughly in line with net income over several years?
2. Are receivables and inventory growing much faster than revenue?
3. Net debt / EBITDA and interest coverage today, and after a 40% profit fall?
4. Is the share count rising (dilution) or falling?
5. Is ROIC high and stable compared with peers?

Next: how these numbers reach the market four times a year, in earnings season, guidance and gaps.