Profits VS Cash
Profits is defined as the difference between the total revenue (obtained from sales) and the costs associated to the product or service. Profit is, therefore, what the company earn once it has sold its products or services, discounting the direct and indirect costs of these.
The profits magnitude is the key metric used to measure the performance of a business or company. Several generally accepted accounting rules and procedures are used to determine it. Changes in regulations could influence the result and may differ from reality depending on the criteria and regulations applied.
Cash is the equivalent of oxygen in a spaceship. With no oxygen, the crew of a spaceship cannot survive. If there is no cash in a company, there is no money to pay salaries nor suppliers, and possibly no money to pay debts. Therefore, the business could shrink, and the company could be forced to disappear. On the other hand, when a company has liquidity in its bank accounts (cash), this is a symptom of a positive evolution, although it is not necessary to keep a fixed picture, but rather to evaluate the cash situation over time to verify that cash is really being generated and that it is sustainable.
How to obtain cash?
Cash or money can be obtained through four ways:
- The most logical one: by the profits obtained from its operations, that have been transformed into available cash.
- By divestment or sale of assets.
- By borrowing (indebtedness).
- By the contribution of capital by shareholders or partners and operating or investment subsidies.
The more desirable would be to obtain cash from the company’s activity, i.e. its operations, and for this cash to be distributable to its shareholders, which is known as Free Cash Flow.
What is Free Cash Flow and how to calculate it?
Cash flow is the movement of cash in and cash out over a period. As inflows exceed outflows, cash is accumulated. There are different meanings of the term “cash flow”:
- The cash flow to shareholders, among other meanings, Equity Free Cash Flow (EFCF), which indicates the money generated and available to remunerate shareholders.
- Capital Free Cash Flow (CFCF) which indicates the cash generated and available to remunerate capital or permanent resources including shareholders and lenders (long-term financial creditors). This concept is the same as the concept of Free Cash Flow (FCF), i.e. cash flow generated and available to remunerate its Permanent Resources. We will focus on the latter.
Free Cash Flow is the cash flow obtained from the company’s operating activities after deducting investments to maintain the business. In other words, it is the money generated by the business, after deducting the operating costs incurred and which can be used to remunerate shareholders, financial creditors and meet investments in working capital or various fixed assets necessary for the business.
Therefore, FCF takes the cash flows generated by assets into account regardless of how they are financed.
Free Cash Flow (FCF) is an important magnitude since it allows us to measure whether the investments necessary to maintain the business or the interest and dividends paid are very high or not in relation to the cash flow generated by the business activity.
