FINANCIAL VALUE = FCF  & ROIC

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

– – Warren Buffett, 2007 Chairman’s Letter for Berkshire Hathaway


Fresh out of college, when I was an Analyst at Mercer Management Consulting is when I first learned about Return on Invested Capital (ROIC) and Free Cash Flow (FCF). I have to admit, I was one of those guys that thought profit and income were the most important components of value.

Sadly, I was misinformed and just wrong. I read, mostly skimmed, through the 800+ pages of the enormous and enormously boring bible textbook Valuation, written by McKinsey experts. If you want to become an expert at valuation then the book is really the bible on valuation, but if you want to simply understand why ROIC and FCF are incredibly important, and how to grow them, read on.

 

Invest in Company 1 or Company 2?


Let’s start this off with a choice for you. Imagine you are an investor, and you have a choice between two companies to invest $100,000 for 1% ownership of whichever company you choose. The two companies are growing profit at the same growth rate. But, over the past 5 years, company 1 has generated $20 million in profit, while company 2 has generated $15 million in profit. Their profit growth is represented in the following chart. Which company should you invest in?

FCF ROIC

Yes, this is a trick question. While profit (i.e., net income) is important to the business, how much cash (i.e., Free Cash Flow) a business creates is typically the underpinning of a business’ financial valuation. Let’s go back to company 1 and company 2.

While company 1 generated “big profit”; it took substantial invested capital to generate the profit. Invested capital is the amount of money that has been invested in a business for purchasing inventory, equipment, property, leases, and funding the difference between accounts receivable (i.e., how much money is owed by customers to the business) versus accounts payable (i.e., how much business owes vendors). You can think of company 1 as a traditional retailer, that necessitates a lot of inventory, buildings, and equipment for their stores. And, as the retailer grows it needs more invested capital to open up new stores.

Take a look below. In our example, over 5 years, company 1 needs $15 m ($3 m a year over 5 years) in invested capital to create $20 m in profit. In the end, company 1 generated $5 m in free cash flow over the past 5 years.

FCF ROIC

Now, let’s take a look at company 2, which needed only $3 m in invested capital to generate $15 m in Profit and $12 m in free cash flow.

FCF ROIC

You can think of company 2 as a successful online software company. It took some money to get the business going, but once it started, it didn’t need much in terms of invested capital to fuel its growth. Online software companies don’t necessitate much in terms of inventory, property, or equipment, hence they are often called “capital efficient”, where the majority of profit generated goes straight to generating cash and doesn’t have to be reinvested to grow the business.

So, if given the choice of getting 1% of company 1 or company 2 for $100,000 investment, company 2 is the hands down choice. While company one is creating more profit, company 2 is generating much more cash, given the investment. And, in business, cash is king.

 

FCF & ROIC – The Equations


While profit, gross margin, operating margin, and revenue are all important, they are still only pieces to the ultimate scores, which are free cash flow and return on invested capital. Let’s go over some of the semi-technical equations to get from an income statement and balance sheet to free cash flow and return on invested capital.

Free cash flow can be calculated from an income statement and balance sheet. Below is the equation.

Free Cash Flow (FCF) =

Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
+ Depreciation and Amortization
– Changes in Working Capital (Growth in Assets – Growth in Liabilities)
– Capital Expenditures (Property, Plant, and Equipment)

Return on Invested Capital is usually represented as a percentage or ratio, and is calculated:

Return on Invested Capital (ROIC) =

Earnings Before Interest & Taxes (EBIT) x (1 – Tax Rate)
÷ (Total Assets – Cash – Total Liabilities)

A return on invested capital (ROIC) that is above 15% is typically very strong since the company is generating a 15% or greater return on the money invested in the business. Referring back to our investment option with company 1 and 2, using back of the envelope math, they are both generating strong ROIC, though company 2 is really, really strong.

 

Why is Free Cash Flow and Return on Invested Capital Important?


The financial output of strong strategy is an improvement of FCF and ROIC, with the crux of strategic decisions being what investments of capital, time and resources will generate the greatest short- and long-term returns. The success of an organization can be boiled down to a series of return on investment decisions, and the accumulation of those decisions determines an organization’s free cash flow and return on invested capital. While people typically understand the concept of revenue and profit, there is often a general naivety to the concepts of free cash flow and return on invested capital within organizations, which can negatively impact the quality of decision-making. Strategic leaders need to use the concepts of free cash flow and return on invested capital as guiding principles in their framing of a situation and their decision-making.

 

How do you grow Free Cash Flow and Return on Invested Capital?


Fundamentally, there are three ways to grow FCF and ROIC.

1. Create and execute differentiated and aligned strategies
2. Optimize and actively manage working capital
3. Optimize investment in property, plant and equipment

 

1. Create and execute differentiated and aligned strategies


Sounds obvious, but too many companies are pretty much run by the finance department, focusing way too much effort on budgeting, cost containment and squeezing out every last efficiency out of the business. Typically, not enough time is spent on growth strategy. If you want to grow FCF and ROIC, grow the company. If you want to grow the company, figure out your target customer, what is important to them, how you can drive more value for them than competitors, how you can create and sustain competitive differentiation, and then figure out your core competencies, budgets, initiatives, etc. Most leadership teams get the strategy equation wrong and focus on the financial outputs and goals, which are simply the output of more loyal customers and more new customers, which is a function of driving a superior customer value proposition over competitors.

 

2. Manage working capital


If you have ever been in an organization that barely made payroll, you probably know what managing working capital means first hand.

Net Working Capital = Current Assets – Current Liabilities

Current assets are assets that are expected to turn into cash within 12 months; the three main ones are cash, accounts receivable, and inventory. Current liabilities are obligations that need to be paid within 12 months, the main ones typically being accounts payable (money owed to vendors), interest payments on loans, and loan principal due within 12 months. In actively managing working capital, here are some best practices:

Audit your cash conversion cycle

Mapping out and auditing the process to pay and collect cash can be eye-opening and reveal opportunities to improve the cash conversion cycle. When you map out each step from receiving an invoice or PO to an actual payment you’ll be able to identify gaps and bottlenecks in your cash conversion. Map out the ordering and subsequent accounts payable process, the order entry process, the inventory control processes, the planning process, the order fulfillment process, the shipping or distribution process, the billing and subsequent accounts receivable process, and the funds’ transfer process. The cash conversion cycle approach helps identify the longer segments and attack them. I’ve seen the time it took to get information to the accounting department to initiate a bill was nearly ten business days, to prepare the invoice for billing took another ten business days, to send the invoice through the mail was another five business days, five more days in the return mail, another five business days to process the check and deposit the funds in the bank. That is 35 days of cash owed to a company just stuck in poor processes. Cash is king.

Stretch accounts payable

Accounts payable can be viewed as a short-term loan from vendors, as they often provide products or services with the promise of being paid in 30, 60 or even 90 days from delivery of the products or services. The cumulative payments an organization owes to their vendors is their accounts payable. Having worked with many companies, stretching accounts payable can be painful and risky because it can damage your relationship with vendors. While stretching accounts payable can be used as a short-term way to conserve cash, just make sure you don’t stretch vendors too much that they reduce their service levels, de-prioritize you as a client, or stop doing business with you. If you want a longer-term accounts payable strategy, re-negotiate with your major vendors on payment terms. Every 15 or 30-day extension in payment terms, can add up to material improvements in FCF and ROIC. One of the most critical aspects of stretching out accounts payable is constant communication between finance & accounting teams, the various functions that may be impacted, and the vendors. I’ve seen some really messy situations and actual business interruptions, because the finance & accounting team didn’t communicate with the functions that they were in arrears with some vendors, and those vendors disrupted their service. In the end, it is often important to a relationship to pay within agreed upon terms, and when organizations get a little too greedy trying to stretch vendors, it often ends up hurting the organization.

Reduce costs

 Accounts payable is a function of the cost structure of a company. If you want to grow FCF and ROIC reduce your cost structure. First, attack the product and partner costs. With product costs focus on cost engineering your product, manufacturing processes, logistics, packaging, etc. With partner costs, start with trying to eliminate partners that are low value and high cost, then focus on demand management, by driving down the initial demand for partner services and products. Once those steps are taken, when contracts are up, go through a proper RFP and/or bidding process first with commodity-oriented products and services, and then with more strategic partners. The last step in a cost reduction project is to focus on personnel costs, focusing on those roles that may be lower value and/or potentially consolidated.

Accelerate account receivables

The flipside of stretching accounts payable is accelerating account receivables, or reducing the time period between when an organizations’ customers receive products and services and actually pay for those products and services. If you are a consumer-facing business, you don’t have to worry as much about accounts receivable since most payment is made by credit cards or cash. But, if your customers are businesses, then accounts receivable, can be an important part of managing cash. Either way it critical to set expectations of payment terms upfront with customers, and to think through incentives to pay on time or early and repercussions for late payment and potential collections situations. Early payment incentives can be in the form of additional discounts, access to priority shipment, access to high-demand inventory, and increased service levels. In most companies, it is important to make someone accountable for managing accounts receivable, which entails constantly communicating with customers in arrears, reporting on how old and large the arrears are by customers, delaying service or shipment of products for customers in arrears, and potentially handing over delinquent customers to a collection agency.

Turn inventory

In an organization that typically carries a lot of inventory, like a manufacturer, consumer goods company, or retailer, trying to increase the efficiency of the inventory, or inventory turns (cost of goods sold / average inventory) is critical, since inventory can often represent a major part of the capital tied up in a business. Generating better inventory turns is really a function of improving the demand planning and supply management of a business. Demand planning is forecasting demand of products and services, while supply management involves fulfilling the demand for a product or service. There are multiple levels of sophistication with demand planning, but often the best methodologies use a combination of historical data, predictive analytics, sales forecasts, and customer sales trends and input. While best practices in supply management typically necessitate the use of lean or six sigma methodologies, which encompass trying to minimize the amount of inventory necessary to fulfill the demand. We go over lean and six sigma tools in the process section.

 

3. Optimize investment in capital expenditures


One of the other major elements of ROIC and FCF is capital expenditures, which includes purchases or leases related to property, plant & equipment (PP&E). Often, these are fixed assets, which are those assets that are non-liquid or not easily turned into cash. With capital expenditures, the best practices include:

Improve the utilization of capital

 One of the easiest ways to increase the value of a company is to better utilize equipment and capital. If a plant runs one shift, are there ways to get to two shifts, three shifts? Are there new potential product lines, ways to drive demand of existing products, other players that need capacity? Can throughput be increased by leaning out processes?

Improve the life of capital

Another important way to drive ROIC is to lengthen the life of capital. Instead of a new piece of equipment are there modifications that can be made, better maintenance, etc.?

Conduct cost-benefit analyses

Capital expenditures are meant to improve the business by either improving revenues and/or costs. Before spending the precious capital of a business, make sure you truly understand the financial benefits of the property, plant or equipment, versus the total costs of ownership and the expected lifespan of the property, plant or equipment.

Establish credit or get a loan

You have three ways to pay for capital expenditures. If you have a ton of free cash flow, you can have the business pay for capital expenditures. The second one is to get investors to invest money into the business for equity, which can get expensive divvying up the ownership of more and more of a business. Or, you can establish a credit or loan facility with a bank, and pay interest on monies used to purchase property, plant or equipment. Hopefully, your financials, balance sheet, and business are attractive enough for a credit facility and loan, since you should expect a higher return on the money versus the interest you have to pay.

 

NEXT SECTION: PROFIT TREES