Cash Flow Drivers

What Drives Cash Flow in Business?

When reviewing the financial performance of a company, whether it be for purposes of evaluating a potential investment or internal financial planning, it is critical to identify the underlying drivers of cash flow.

As the common saying goes, “Cash is king” – as the majority of companies fail not from the inability to produce sales but rather from running out of cash.

Ultimately, all companies strive to efficiently allocate their cash and maximize their free cash flows (FCFs). Achieving growth requires continuous reinvestments and spending on profitable projects.

Examples of Cash Flow Drivers

While not meant to be an all-inclusive list, some of the major cash flow drivers most applicable to corporate valuation include:

• Revenue Growth – Customer Count, Average Revenue Per User (ARPU), Average Selling Price (ASP)
• Profit Margins – Gross Margins, Operating Margins, EBITDA Margin, etc.
• Net Working Capital (NWC) – Accounts Receivable (A/R), Inventories, Accounts Payable (A/P), Accrued Expenses
• Capital Expenditures (CapEx) – Maintenance and Growth CapEx
• Capital Structure – Debt Financing and Issuance of Equity Shares
• Tax Rate % – Varies by Jurisdiction and Corporate Structure

The extent to which each factor contributes to the net change in cash will differ by the company and the industry.

Learning to identify the specific drivers with the most significant impact on the valuation of a company directly improves the accuracy of financial forecasts.

For instance, in the case of a highly capital-intensive company, an extensive amount of time should be spent on assessing historical capital expenditures and management projections due to how substantial of an impact CapEx is on the cash flows of the company.

How to Identify the Cash Flow Drivers?

From the perspective of companies, cash flow models enable the management team to assess their solvency, which is the ability of a company to meet its long-term debt obligations (i.e. interest payments).

In addition, cash flow models can be used to gauge the relative liquidity position of the company – which could ring alarm bells internally if external financing is required for the company to remain afloat.

Generally speaking, monitoring the cash flows of a company and understanding the impact of the drivers of the cash flow leads to better corporate decision-making, which decreases the risk of the company falling into trouble (e.g. defaulting on debt obligations, requiring financial restructuring).

Short-term and long-term patterns can also become more apparent through the analysis of multi-year models. For example, a company could better anticipate and retain more cash on hand (i.e. increased liquidity cushion) if performance is cyclical to macro-trends, which increases the odds of weathering the storm in case of a downturn.

But other than the downside protection supplied by cash flow models, such models also help companies set targets and budget appropriately based on the projected cash flow performance.

Figuring out the main drivers of cash flows can also help gauge the impact of certain investment and capital allocation decisions, which in turn can help guide future decisions.

Revenue Growth Analysis

Contrary to a frequent misconception, positive revenue growth does NOT always convert into positive cash flows.

If revenue grew by $10 million over one year, but $20 million in total spending was required to fund the growth, the net cash impact was most likely negative.

In comparison, revenue growth that stems from increased selling volume and/or pricing power (i.e. raising prices due to increased demand) would be far more preferable.

One of the primary reasons that revenue growth is listed here is that many companies do not reach their break-even point until a certain amount of revenue is generated.

Once the break-even is met, revenue beyond that point is brought in at much higher margins (and increases cash flow).

Learn More → Hedge Fund Primer

Profitability Analysis

Gross Profit Margin and Operating Margin

The revenue and break-even point concepts are directly tied to the profit margins of the company, and more specifically, the gross margin and operating margin.

The cost of goods sold (COGS) and operating expenses (OpEx) are what set a company’s break-even point – OpEx in particular since they are typically fixed costs whereas COGS are typically variable costs.

The gross margin is the difference between the direct costs of producing a good or providing a service and the amount for which the product/service was sold. Besides COGS, the other major expense line item is selling, general & administrative (SG&A) costs – which consist of indirect operating expenses.

The majority of a company’s expenses are going to be found within either the cost of goods sold (COGS) or operating expenses (OpEx) line item, as expenses like interest expense and taxes are typically much smaller in comparison.

The further one goes down the income statement and as more items are expensed, the net income (“bottom line”) is reduced – which effectively represents the amount of post-tax cash remaining that can either be:

1. Re-Invested into Operations (and Added to the Accumulated Retained Earnings Balance)
2. Issued as Dividends to Equity Shareholders

Net Working Capital and Change in NWC

The net working capital (NWC), a measure of the liquidity of a company, is another important cash flow driver. Note the net working capital calculation is a measure of operating activities and excludes:

• Cash & Cash Equivalents (e.g. Marketable Securities, Commercial Paper)
• Short-Term and Long-Term Debt & Interest-Bearing Instruments

Cash and cash equivalents like marketable securities can earn modest returns and be categorized as investments, whereas debt and any debt-like instrument are closer to financing activities as opposed to operating activities.

Interpreting Change in NWC

To provide some general guidelines for net working capital:

• Increase in Current Asset → Decrease in Cash Flow
• Increase in Current Liability → Increase in Cash Flow

And if we reverse those previously stated guidelines for NWC:

• Decrease in Current Asset → Increase in Cash Flow
• Decrease in Current Liability → Decrease in Cash Flow

For example, if accounts receivable (A/R) – an operating current asset – increases on the balance sheet, that means the company is owed more cash by customers that paid on credit, not cash.

Therefore, until the customer issues the cash payment to the company for the products/services already received, the cash is NOT in the possession of the company, which decreases its cash flow.

But once the customer payment is received in cash, the A/R balance would decline and increase the company’s cash flow.

On the other hand, if accounts payable (A/P) – an operating current liability – increases on the balance sheet, then that would mean the company has not yet paid suppliers/vendors for products/services already received.

While the payment will eventually need to be made (since otherwise the supplier/vendor would terminate the relationship and likely pursue legal action to retrieve the due payments), the cash is freely in the possession of the company for the time being and increases cash flow.

Working Capital Peg: Minimum NWC Needs

For the operations of a business to continue running as usual, there is a set amount of liquidity required to be on hand.

The minimum NWC amount – formally referred to as the working capital peg – is unique to the company and the industry it operates within, but as some general rules:

• High NWC Requirements → Lower Cash Flow
• Low NWC Requirements → Higher Cash Flow

The intuition behind NWC is that the more capital that is required to be on hand, the more cash is tied up in operations that cannot be used for discretionary purposes (and vice versa).

Cash Conversion Cycle (CCC)

One important working capital metric is called the “cash conversion cycle”, which is the number of days that cash is tied up in the operating cycle of the company.

The cash conversion cycle (CCC) measures the length of time between the initial purchase of raw materials (i.e. inventory) until the collection of receivables (i.e. A/R) from customers – or said differently, the duration between the use of cash and the subsequent recovery of cash from operations.

The calculation of the cash conversion cycle is comprised of the following formula:

• Days Sales Outstanding (DSO): Accounts Receivable Days (A/R) measures the number of days it takes on average for the company to collect cash from customers on sales made on credit. The shorter the collection period is, the more positive of an impact there will be on cash flow.
• Days Inventory Outstanding (DIO): Inventory Days measure the efficiency at which inventory is “turned over” (i.e. sold to customers). If the DIO has been declining, the turnover of inventory is increasing, meaning the company is selling its products faster – leading to increased cash flow.
• Days Payable Outstanding (DPO): Accounts Payable Days (A/P) measures the number of days it takes on average before supplier/vendor payments are made by the company for products/services received in the past. The longer the payables can be extended out (i.e. the delay of required payments), the more beneficial it is for the company as it can hold on to the cash for longer, which increases cash flow.

Capital Expenditures (Capex)

Capital expenditures, or “capex”, refer to the purchases of fixed assets with useful lives longer than one year.

Capex is relatively straightforward in that highly capital-intensive industries will have lower cash flow, as there are periodic CapEx spending needs.

Industries that are capital-intensive tend to be more cyclical, which causes the company to hold more cash on hand. But while discretionary capex, also known as growth capex, can be reduced during difficult times to limit the damage to profit margins, maintenance capex is required to keep operations intact (e.g. replacement of broken equipment or machinery).

Capex is not recognized on the income statement under accrual accounting, so depreciation – the allocation of the outlay of cash related to the purchase of fixed assets – is added back on the cash flow statement (CFS) as a non-cash expense.

Capital Structure: Mixture of Debt and Equity Financing

The capital structure refers to how a company’s operations are funded – i.e. the mixture of equity vs. debt.

A higher debt component (% of total capitalization), if completely isolated, results in higher interest expense payments, which appear on the income statement and reduce cash flows. There is, however, a “tax shield” benefit from the interest expense.

The borrowed funds (i.e. debt financing) are typically used to fund growth and enable the company to pursue projects, which are ideally profitable enough to offset the costs of financing.

If debt is added to the capital structure, initially the weighted average cost of capital declines due to the lower cost of debt and tax-deductibility of interest (i.e. the “tax shield”). But eventually, past a certain point, the risk of default (and bankruptcy) outweighs the benefits of debt financing, which causes the cost of capital to trend upward (i.e. the risk increases for all stakeholders, not just debt lenders).

Cash Flow Drivers and Types of Free Cash Flow (FCF)

For clarification, the free cash flow (FCF) of a company represents the discretionary cash flow remaining once recurring expenditures accounting and necessary adjustments are accounted for, depending on the type of free cash flow in question.

There are two main types of free cash flows:

1. Free Cash Flow to Equity (FCFE)
2. Free Cash Flow to Firm (FCFF)

Unlike the FCFE, the FCFF is an unlevered metric and capital structure neutral, which means it is unaffected by the financing decisions of the company. However, FCFE is dependent on the capital structure as the cash flows pertain only to equity holders.

Cash Flow Drivers – Excel Template

Now that we’ve discussed each of the major cash flow drivers and other side considerations that impact a company’s liquidity, we can see the concepts in practice.

To access the Excel file and follow along, fill out the form below:

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1. Free Cash Flow (FCF) Calculation

As mentioned earlier, there are two main types of free cash flow. However, for illustrative purposes, we’ll use the simplest FCF calculation.

FCF will be calculated by subtracting CapEx from Cash from Operations (CFO).

“Cash from Operations” is the first section of the Cash Flow Statement (CFS), whereas CapEx is the main cash outlay in the “Cash from Investing” section.

The inclusion of CapEx, while other discretionary investments are excluded, is related to how CapEx is mandatory for operations to continue as is.

2. Cash Flow Drivers Projection Assumptions

For our modeling exercise, we’ll assume there are three different cases, which we’ll use to see the various cash flow impacts each factor has.

1. Base Case Scenario
2. Upside Case Scenario
3. Downside Case Scenario

Base Case Scenario Assumptions

• Revenue = $200m
• % Gross Margin = 70%
• % Operating Margin = 20%
• Interest Expense = $0m
• Tax Rate = 30%

Since we’re provided with the gross margin of the company, we can start by calculating the gross profit.

• Gross Profit = (% Gross Margin) × Revenue
• Gross Profit = 70% × $200m = $140m

Next, we can calculate the cost of goods sold using the following formula:

• COGS = Gross Profit – Revenue
• COGS = $140m – $200m = –$60m

Note that COGS has a negative sign in front to show it’s an outflow of cash.

Next, the Operating Income (EBIT) can be calculated by multiplying the operating margin assumption by the applicable revenue amount, much like our calculation of gross profit.

• EBIT = (% Operating Margin) × Revenue
• EBIT = 20% × $200m = $40m

Moving to the pre-tax income (EBT) line, we must deduct the non-core, interest expense, which is zero in this case.

• Pre-Tax Income (EBT) = EBIT – Interest Expense
• Pre-Tax Income (EBT) = $40m – $0m = $40m

Then, the next step is to tax-affect the earnings before taxes (EBT) to arrive at net income.

• Net Income = Pre-Tax Income – Taxes
• Taxes = 30% × $40m = $12m
• Net Income = $40m – $12m = $28m

In the subsequent steps, we’ll complete the exact same process for the upside case.

Upside Case Scenario Assumptions

• Revenue = $240m
• % Gross Margin = 60%
• % Operating Margin = 15%
• Interest Expense = –$5m
• Tax Rate = 30%

Under our upside case assumptions, the company’s financials consist of:

• Gross Profit = $144m
• Operating Income (EBIT) = $36m
• Pre-Tax Income = $31m
• Net Income = $22m

Once the upside case net income calculation is complete, we’ll repeat the process for the downside case using the following assumptions:

Downside Case Scenario Assumptions

• Revenue = $160m
• % Gross Margin = 50%
• % Operating Margin = 10%
• Interest Expense = –$10m
• Tax Rate = 30%

For our downside case, the company’s financials consist of:

• Gross Profit = $80m
• Operating Income (EBIT) = $16m
• Pre-Tax Income = $6m
• Net Income = $4m

The net margin for each scenario is 14.0%, 9.0%, and 2.6%, for the Base, Upside, and Downside cases, respectively.

3. Cash Flow Drivers Forecast Example

In the next part of our modeling exercise, we’ll be calculating the two required inputs for our simplistic calculation of free cash flow:

1. Cash from Operations (CFO)
2. Capital Expenditures (CapEx)

The starting line item on the cash flow statement is net income, so in the model, we link to the “bottom line” of the income statement.

Next, we’ll add back the non-cash depreciation expense, which we’ll assume is equal to 2% of revenue each year, and then subtract the increase in NWC. The increase in net working capital is $5m, so we must subtract that value by placing a negative sign in front.

Remember, an increase in NWC is a “use” of cash, whereas a decrease in NWC is a “source” of cash.

For the Upside Case, the change in NWC decreased by $15m (i.e. cash inflow) while increasing by $25m in the Downside Case (i.e. cash outflow).

In the subsequent step, we add up the three lines to get to Cash from Operations (CFO).

• Cash from Operations (CFO) = Net Income + Depreciation – Increase in NWC

Going across from the Base, Upside, and Downside Case, the CFO is $27m, $42m, and –$18m, respectively.

CapEx Assumptions

• Base Case Scenario: $4m
• Downside Case Scenario: $8m
• Upside Case Scenario: $12m

The intuition here is that the Base Case represents normalized CapEx spending (2.0% of revenue).

In the Upside Case, CapEx increased to $8m (3.3% of revenue), as growth comes at a cost – and those “costs” refer to reinvestments, most notably CapEx.

But in the Downside Case, CapEx is the highest out of the three scenarios at $12m (7.5% of revenue), which implies that as a result of underperformance, the company was forced to spend a significant amount on growth CapEx.

Yet the increase in CapEx spending does not translate to immediate revenue, as it could require several years for the fixed assets to generate the amount of revenue originally expected.

For the final calculation in our cash flow model, we simply deduct CapEx from Cash from Operations under each case.

• Base Case Scenario: $23m
• Upside Case Scenario: $34m
• Downside Case Scenario: –$30m

If a cash flow deficit occurs (i.e. negative cash balance), it is imperative for the company to obtain financing of some sort as soon as possible or via other means like the sale of non-core assets and use those proceeds to fund ongoing working capital requirements or to meet debt-related payments, namely interest expense.

The FCF conversion yield – which we calculated as FCF divided by revenue – is 11.5% in the Base Case and 14.0% in the Upside Case. However, due to the lower margins, higher interest expense, and increased NWC requirements, the FCF yield is –18.5% under the Downside Case.