Cash flow check on accounting

Cash flow from operations or free cash flow?

Pardon the technical post and the prosaic title, but I hope it will explain why I rejected Smith & Nephew but retain Castings in the Thrifty 30. Smith & Nephew makes human parts (replacement knee joints for example) and Castings makes car parts, like steering knuckles.

Smith & Nephew has factories, Castings has foundries. Both are capital intensive industries requiring continuous investment in equipment and facilities to manufacture more efficiently, stay competitive and grow.

Both companies looked like good companies at cheap prices according to the accounting fundamentals: return on equity and leverage primarily. But when I looked at free cash flow return on equity, I began to doubt them.

First a reminder. Free cash flow is net cash from operations plus net capital expenditure (usually negative because a growing company will be spending cash on new facilities rather than selling-off facilities it no longer needs). Over the very long term it ought to be similar to net profit, the difference between the two being a matter of timing. Major items of capital expenditure are charged to the cash flow account immediately but they are depreciated in the profit and loss account, and the charge is spread over as many years as the factory or machine is deemed useful by the company’s accountants.

I use free cash flow to check the accounting doesn’t flatter profits.

So, given that free cash flow return on equity has trailed return on equity at both Castings and Smith & Nephew, why take a more lenient view on Castings?

The first thing to say is because they’re growing companies both deserve leeway. My measure of free cash flow includes all capital expenditure, whether it’s to replace worn out facilities or for new investment that will help the company grow.

Since I’m comparing the net profit the company actually reported to free cash flow, it’s not fair to include the cost of new investment in addition to that required to maintain profits, from which the company has yet to profit. The problem is I don’t know how to differentiate new capital expenditure from replacement capital expenditure. I don’t think it’s possible to tell from a company’s published accounts.

And since new capital investment is required if a business is to grow, it seems senseless to penalise it in the free cash flow return on equity calculation.

The kludge I’ve settled on for the time being is to look at net cash flow from operations. This measure excludes all capital expenditure including that required for maintenance. It really should be higher, on average, than net profit, from which depreciation has been charged, even in a growing company.

If net cash flow from operations is lower than net profit over ten years, then I think that rules a company out, and so it has been at Smith & Nephew, averaged over the last ten years:

Mind you, looking at that chart I’m wondering if I’ve been a little harsh. Over the last three years net operating cash flow ROE (blue line) has surged past adjusted return on equity (red line). If the accounting measure of profitability remains nestling nicely between the two cash flow measures, it begins to look more credible.