Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, August 16, 2011

The Money Machine Making Free Cash Flow

This is Part 4 of a Series. Go to Part 3: Showing You the Money and the Natures of Cash Flow

Save the Investing and Financing portions of Cash Flow, Operating Cash Flow just lacks that discerning appeal innate to the Income Statement. You've got certain adjustments which are really confusing, and immediately churned out at the bottom is a net figure; you can hardly decipher where and how cash was made and paid! What we want to see is how the business makes it money...

Seeing the Money Machine in Action. The Direct Method of Cash Flow Statement cleanly illustrates where and how money is paid and made in the business. 
Now imagine an Operating Cash Flow statement which can tell you, spot on, the cash receipts coming in, and cash disbursements going out, in an organized way similar to the kind of intuition you get when you look at the Income Statement. This is the Direct Method of Cash Flow Statement.

So you’re telling me there is such a thing called Direct Method of Cash Flow Statement? Yes. Then why hasn’t this been used in the first place? I’m not so sure myself (I'm curious, too, so you may comment below or message me if you know why). Companies and regulating government agencies seem to prefer the Indirect Method of Cash Flow Statement because of how it readily reconciles with the Income Statement’s Net Income. After all, because of the reconciling adjustments, it actually holds information you need to convert it into a Direct Method. Its proforma just needs a slight overhaul and reorganization to be easily understood. And that’s just exactly what we’re gonna do and demonstrate.

Peeking into Jollibee’s Cash Hive
Disclosure: I currently don't own any Jollibee shares.

So let’s take a look at a favorite company of mine, Jollibee (PSE: JFC). Taken from its 2010 Annual Report, below are its Income Statements and Cash Flow Statements for the years 2008 to 2010. From these, I derived Free Cash Flow Statements (we'll explain later what this is). Click on the labeled tabs at the bottom of the spreadsheet to switch through these different financials.

So how do we recast Operating Cash Flow? Notice that the first entry under Cash Flows from Operating Activities is Income before income tax. From there, certain adjustments and impairment reversals were made. Considered, too, were working capital changes. Interest received and paid were directly identified, as well as contribution to plan assets and income taxes paid, before finally arriving at the Net cash provided by operating activities.

Free Cash Hoard. While Operating Cash Flow does show internal-cash generation, it still has to be further qualified by deducting Capex from it. After all, we don't want to accumulate wealth in depreciating fixed assets. What we're after is free cash we can pocket and spend.
Thus, the starting point is to dissect Income before income tax into its finer elements. That's exactly what I did by color-coding these elements in blue (see under the Income Statement). After that, you just have to identify where each Operating Cash Flow element (red-coded) should appropriately fall under which Income Statement element (blue-coded), to qualify cash transactions which is represented by those green-coded figures under the Free Cash Flow Statement. Congratulations, you now have visibility how much cash is coming from (see revenues collected, interest income received, other income collected) and going out where (direct costs paid, operating expenses paid, interest expense paid) and you can now tell how the business is internally-generating its cash hoard.

While Jollibee reports profits of Php2.32B, 2.67B, and 3.21B for the years 2008, 2009, and 2010, respectively, we want to validate whether these are really received in cash terms. Comparatively, Net Operating Cash Flows were Php4.62B, 6.55B, 5.31B. Why the big discrepancy?

You see, Operating Cash Flow in itself does not complete the picture of a money-making machine, that is the business. We also have to consider Capital expenditures (orange-coded) since these are, despite being capitalized and not immediately expended in the Income Statement (they are, instead, expended little by little through depreciation), essentially economic cash costs in doing business. Surely, no aspiring rich wants to accumulate his wealth in depreciating fixed assets. Naturally, he wants to hoard cash or accumulate them in the form of liquid or marketable assets that increase in value. Thus, after deducting Capex from the Net Operating Cash Flow, we now arrive at Free Cash Flow, the true measure of cash profits.

The Sweet Sound of Cash Registers. The well-oiled money-making machine that is Jollibee just never stops making money.
Going back to Jollibee, Free Cash Flows are Php2.00B, 4.00B, and 2.86B for 2008, 2009, and 2010, respectively (paralleling their net income counterparts). Imagine, despite countless, cash-hungry initial outlays for the construction and openings of new branches, Jollibee, amazingly, has still routinely been making cash profits (not just some, but tons of it). It makes the business of money-making look so easy.

Here's a final kicker: With ending equity standing at Php15.18B and 16.66B for 2009 and 2010, respectively, Return on Equity (that compounding power of a stock) is approximately at 20%. That's not just some ordinary, ambiguous ratio taken somewhere and thrown off in front of you. Allow me to repeat so you can appreciate the gravity of this matter... That's 20% of liquid ROE we're talking about!


  1. I have a question... why is there a big drop in the free cash flow on 2009 to 2010? is there really an increase in construction in opening new branches because the expenses and capital expenditures from 2009-2010 is almost the same...I'm a newbie and i want to have a very informative website...thanks...keep it up

  2. Hi Jerold182, thanks for dropping by. Good question; it actually made me dig deeper in their financials to see no. of branches. Here are the facts:

    Year 2010
    365 Franchised
    352 Company-owned
    717 Total of Jollibee stores

    Year 2009
    355 Franchised
    331 Company-owned
    686 Total of Jollibee stores

    Above doesn't include subsidiaries' branches (e.g. Chowking, Mang Inasal, etc.) Just by looking at company-owned branches, which is logical since that is where the direct outlays are, there has been an increase of 6% (21 additional branches).

    Free Cash Flows are often more erratic compared to Net Income. The key is to look at periods spanning years (if possible 8 to 10 years). They should approximate each other when summed up to guage if the business is realizing its profits in cash. The big drop in free cash flow you observed in 2009 to 2010 may look insignificant (yet to be confirmed) when viewed from a grander picture.

  3. the reason that i am hesitant in investing in jollibee stocks is because of the low about estimated 3.37 per share on 2011...and the cost of jollibee per stock is 86.95php...that's only 3.88 percent ROI if you invested now... although jollibee is a superb company...i think it is expensive in my opinion...or is it? what's your thought on this?

  4. Yes, that's true. I only discussed Jollibee on its level as a business. But as a prospect investment, there's also the price you have to pay for which definitely has to be considered. And I agree with your view that it is way, way too premium now from its intrinsic value.

  5. I'm amazed. Transparent pala ang Jollibee hahaha

    - TSO

  6. @TSO: My initial thought is similar: where you have this holding/conglomerate business owning several subsidiaries, and that being the case, you've got ambiguity in its asset accounts (i.e. investment in associates/subsidiaries), and consequently in its operating cash flows. Looks like it's not the case with Jollibee =D Any further thoughts on this?



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