How to use cash flow to assess a company's quality↓
In part 1 of this series, we discussed free cash flow, what it is and different ways to use it. In part 2, I'll focus on ways to use cash flow to assess a company's quality.
Meaning how efficient and effective their primary business operations are. Three metrics we'll review are cash conversion cycle, cash return on invested capital, and cash generating power.
The cash conversion cycle, or CCC, is calculated as the sum of Days Inventory Outstanding (DIO) plus Days Sales Outstanding (DSO), minus Days Payable Outstanding (DPO).
CCC = DIO + DSO - DPO
You can calculate it by yourself however, it's much easier to simply look it up as most sites will have it already calculated for you.
This is a cash flow metric that measures the timeframe it takes to resource inputs such as inventories, receivables, raw materials, etc. into cash. Essentially it measures how efficiently a business manages its cash. Companies with shorter cycles can purchase inventory, sell it, and convert it to cash in less time. As you can imagine, the lower the number the better.
The CCC can be viewed as a relative valuation metric, meaning the number by itself really doesn't tell you much. In order to assess the metric you should ideally compare it to historical averages or competitors. You also want to ensure there is a consistent pattern from year to year. Large jumps here and there can indicate either cash shortages or inventory mismanagement.
Also known as cash return on cash invested.
CROCI = Free Cash Flow / Invested Capital (Total Equity + Long-Term Debt)
It's somewhat of a valuation metric and was originally developed by the Deutsche Bank Group. I personally like using FCF instead of EBITDA because ultimately, cash flow is what matters. Let's take a look at Apple as an example:
52,961 / (128,249 + 75,427) = 0.26 = 26%
The original CROCI formula measures the profits of a company compared to the funds required to generate them. However, this equation focuses on returns made with FCF instead of earnings and includes long-term debt in the denominator. This allows the investor to determine management effectiveness with free cash flow.
There's not really a tried and true number to look for but usually any CROCI greater than 15% shows management is strong and the business holds some sort of competitive advantage. As with ROIC and ROE make sure to check the consistency dating back at least 5 years.
This ratio just sounds powerful! But in all seriousness it's actually very useful for testing the quality of a business's primary operations. Since we're removing operating cash flow from other cash inflows, we can determine a company's ability to generate cash purely from business operations.
Cash Generating Power = Operating Cash Flow (OCF) / (OCF + Cash from Investing & Financing Activities Inflows)
Let's use Apple as another example:
66,339 / (66,339 + 125,478 + 202 + 521 + 18,591) = 0.3142 = 31.42%
As you can see from the picture above, if you get confused performing this calculation simply add up the positive numbers in the investing and financing activities section.
While a higher number is better, this is one metric you would definitely want to compare to competitors to determine the quality of a company's business operations. A substantial difference would be indicative of a competitive advantage. Be sure to check this metric over the past 5 years as well to see if there is an up, or down, trend.