So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?

A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE

• Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
• Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
• Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).

FINANCIAL SIDE

• Trade Liabilities – these are accrued expenses yet to be paid in cash (e.g. includes accounts payables and deferred tax liabilities) and unearned revenues, which, while not yet being reported in the income statement as sales, are actual cash inflows
• Financial Liabilities – these are externally sourced cash so no value given. Includes notes payables, short-term debt, long-term debt, etc.
• Accumulated Market Gains – these are cumulative gains under equity attributable to market appreciation of certain assets held, particularly non-core business investments which are reported in their mark-to-market values (i.e. stocks at their current market price). These book value enhancements/detriments (which are also yet to be reported in the income statement since they are yet to be realized), are non-cash, unrealized gains/losses.

Free Cash Hoard = Free Cash Assets – (Financial Liabilities + Cumulative Market Gains)

Cash Hoard is such a conservative measure it only gives bearing and worth to Free Cash Assets after deducting all Financial Liabilities and Cumulative Market Gains. The resulting net figure is akin to the concept of equity—but in this case, we’re talking about the current liquid state of net assets which shareholders have in their possession.

What is its relevance? Comparing this derived figure with your standard equity (i.e. book value) would say a lot about the cash flow dynamics of the business model the company is in. Further, deriving it forces one to dissect the components of assets, liabilities and equity, and in the process be familiar with the financial characteristic of each from a cash-bias perspective—that is to say, how each balance sheet account affects free cash flow. More so, if you are familiar with the discounted cash flow model of estimating intrinsic value, this would be a component of it along those projected free cash flow subject to discounting to present value. Continue to Part 3: FEU's Cash Hoard. And They Said School is Boring...