September 18, 1998
Cash Flow Review, Part 2
On Tuesday, we began to look at Revlon's cash flows, starting by reviewing the top to the bottom of the statement of cash flows. Before we go on, a word about the purpose of the cash flow statement. The cash flow statement reconciles the balance sheet figures shown at the beginning of a period with balance sheet figures at the end. Part of the change in resources flows through the income statement, but not all of the flows of resources can be seen on the income statement. That's how a company can "grow its way into bankruptcy" and that's why investors should not focus exclusively on earnings growth.
Here's why. If a company does an acquisition, which we see in the cash flow from investing activities section:
Acquisition of businesses,
net of cash acquired..........(60.4) (7.1)
You can't back into the actual net cash outlay for inventory by looking at period-to-period balance sheet changes. For the consideration paid by the company, it took in with the acquired corporation its assets and liabilities, including inventories. We can deduce from the period-to-period change in inventories, minus the net cash outlay for inventories shown on the balance sheet, the approximate amount of inventories taken in as part of the acquired company:
Change in inventories = $68.2 million less
Net cash outlay for inventories = $21.4 million
Inventories of acquired companies = $46.8 million.
Free Cash Flow
Free cash flow (FCF) is defined in so many different ways, correctly and incorrectly as the case might be, that one should state what one means by FCF when the term is used. Terms such as EBITDA (earnings before interest, taxes, depreciation, and amortization) and such have so bastardized the concept of free cash flow that you should define your conception of FCF if you want to be understood when using it. Free cash flow for our purposes, then, is earnings plus depreciation and amortization (of goodwill and intangibles, not of regular asset accruals) plus or minus investment. Investment is changes in working capital plus or minus capital expenditures, acquisitions, and divestitures.
In Revlon's case, cash flow from investing is straightforward enough:
Now, for free cash flow, we have to deal with a big slug of "other" in the cash flow statement. This "other" appears on a regular basis in Revlon's operating cash flow statement:
An investor has to decide whether these outlays represent ongoing expenses of doing business and thus reflect the company's ongoing profitability, or whether they can be disregarded in assessing the company's free cash flow. Piecing together a Ron Perelman company isn't the most fun thing in the world, so this may not be the best example for illustrating cash flow. But going through all the notes to financial statements, one can track down some of these off-income statement cash outlays. These include outlays for consolidations of facilities and restructurings taken as "extraordinary items" on past income statements. However, the presentation is not entirely clear. When a company can't present items in a clear manner and presents its second-largest cash outflow item as an "other," it's usually time to move on to a new company to look at.
But we'll stick with this one. We'll assume two scenarios, one in which the outlays are recurring and one in which they are not. The company's free cash flow, then, under the recurring scenario would very simply be net cash flow from operations minus cash used/generated in investing activities:
Net cash provided by (used for) operating activities.....$6.9
Net cash used for investing activities...(108.4) = outflow of $101.5 million
In the second scenario, we have:
Net income (loss)....................$43.6 +
Net cash used for investing activities....(108.4) = outflow of $28.5 million
In either case, granting leniency to the "extraordinary item" and the "other" item, the company is free cash flow negative. For a small, growing company, this might be all right, but cosmetics is a pretty mature industry, and we'd like to see some free cash flows as equity investors. However, that doesn't mean the company is worth nothing. Pushing out for a day a discussion of what cash flow does for valuation, we'll look at that question on Tuesday in Part 3.