Cash Flow from Investing Activities
As the name implies, cash flow from investing activities tracks the cash movement in a company resulting from the company’s investment activities. Table 2 shows the investing cash flow extracted from TexCycle’s Statements of Cash Flows.
|Table 2: Statement of Investing Cash Flow for the Year Ended 31 December 2016 (in RM)|
|(Increase)/decrease in other receivables and expenses||552,900||(758,000)|
|Proceeds from insurance claim on loss of property, plant & equipment||750||8,300|
|Proceeds from disposal of property, plant & equipment||125,000||1,000|
|Addition of property, plant & equipment||(3,990,707)||(4,789,545)|
|Additional investment in unit trusts||–||(3,000,000)|
|Net cash (used in) investing activities||(3,286,876)||(8,489,356)|
The key item under this category is addition (or purchase) of property, plant & equipment. In finance terms, we usually refer to this as “Capital Expenditure”, or Capex.
Generally, there are two types of Capex, one being maintenance Capex and the other being expansion Capex.
Maintenance Capex can be described as the amount the company needs to spend to maintain its current level of business activity. Take a production company for instance. The repair and maintenance costs are charged to the income statement as expenses. But what we deem as maintenance capex is the amount needed to replace existing aging machines and equipment. The capex to replace aging machines is to maintain the earning capacity of the business.
Expansion capex on the other hand is the investment into new machines to increase the capacity of the business.
In most cases it is hard to draw a clear line between maintenance capex and expansion capex, as most of the time, replacing an old machine with a new one will also result in capacity increase.
. The Concept of Free Cash Flow
Free cash flow is a concept that measures the amount of excess cash generated by the company. The “excess” is measured by deducting the cash generated by operation with capex, which is:
|Free Cash Flow||=||Cash flow from operating activities||–||Capex|
The concept behind this is that from the cash that the company generates, the company would need to either invest back into the business to either maintain its capacity or to expand its capacity. Any excess cash balance is technically “free to be used for other purposes”, and thus the term “free cash flow”.
A better calculation would be using maintenance capex rather than capex, which excludes capex used for expansion:
|Free Cash Flow||=||Cash flow from operating activities||–||Maintenance Capex|
However, the difficulty is that the company cash flow does not split capex into maintenance and expansion.
Why is it better to use maintenance capex? The logic goes like this.
Assume Company A generates RM100 million worth of operating cash flow. To be able to continue to generate this level of cash flow, Company A needs to replace machines and equipment worth RM40 million. Thus, Company A’s free cash flow would be RM60 million (RM100 million – RM40 million).
With this RM60 millions of free cash flow, Company A then has a few options on its table. Firstly, Company A can either hold the cash for rainy days or for merger and acquisition opportunities. Secondly, it can consider expanding its capacities with the excess cash. And thirdly, Company A can declare this excess cash as dividend to shareholders.
The third point is crucial. Most investors would relate dividend to profit. In fact, the industry measures dividend in terms of how much dividend is paid out as a percentage of the profit generated (i.e. dividend pay-out ratio). However, if investors understand this concept of free cash flow, dividends are actually paid out of free cash flow, and not profit.
If the company does not have free cash flow, its dividend payment would need to come from other sources of financing, which would be detrimental to investors in the long term.
On the point of capacity expansion; if a company continues to generate negative operating cash flow, then there is no free cash flow. For expansion, the company would need to tap on debts and borrowings. When the operating cash flow is negative, adding the need to pay financing costs would put the company in a very financially difficult situation.
Thus, free cash flow is a very critical and important concept that investors must pay attention to.
Next week, we will explore Cash Flow from Financing Activities and the relationship between Cash Flow from Operations, Investing and Financing Activities.