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Maintainable Free Cash Flow: Separating cash flow maintenance from growth
Why it's important to separate spending on maintenance from spending on growth
10x Hunter
September 16, 2024
Back in June (2024), I was following a trail of interesting articles on finance.
As I made my way down the winding path, I stumbled into an article called M****** F****** Cashflow: Cash generation vs capital allocation.
It was recommended reading and seemed important.
But, I couldn't understand it.
It talks about "Free Cash Flow" and proposes a new financial metric called "Maintainable Free Cash Flow".
I'd heard of "Free Cash Flow" plenty of times.
But, I never really understood it.
So, I was in over my head with a proposal for a new cash flow metric.
I moved on to other things, intending to make another attempt at the article at some point in the future.
And the article found its way into the land of forgotten tabs.
A couple days ago, I was closing out dozens of browser tabs I'd "saved for later".
They were mostly residue left behind by 80 hours of effort focused on trying to understand cash flows.
About 90% of the way through the tabs, I came across the Maintainable Free Cash Flow article again.
It'd been 2 months since my first encounter with it.
It was time to let go.
But, I decided to scan it one last time before parting ways.
😲
To my surprise and delight, I understood it!
It was like one of those moments when you're learning another language and suddenly realize you understand what people are saying.
Better yet, it addressed an issue I'd noticed while studying standard cash flow metrics.
Free Cash Flow (FCF) is supposed to tell us how much of the cash a business generates can be used for discretionary purposes.
And, it does.
It takes a company's Operating Cash Flow and excludes Capital Expenditure (CAPEX) (cash spent on long-term assets used in operations).
The formula is:
Free Cash Flow = Operating Cash Flow - CAPEX
The thing is, it accounts for all CAPEX spending.
It doesn't distinguish:
Required spending: Spending that's necessary to sustain the current level of cash flow into the future.
Discretionary spending: Spending that's optional (and often intended to help increase the business's future cash flows).
So, we can't really see how much of the business's cash flow went to maintenance and how much went to growth.
And, this doesn't just apply to CAPEX spending.
Supporting growth usually requires spending on research, development, marketing, and sales, too.
So, discretionary spending is hidden all over the place.
It affects all our cash flow metrics.
For example, Unlevered Free Cash Flow and Levered Free Cash Flow.
As a reminder:
Unlevered Free Cash Flow (UFCF) is: The cash generated by a business's operating activities, excluding the impact of its Capital Structure (e.g. the cost of debt).
Levered Free Cash Flow (LFCF) is: The cash generated by a business's operating activities that can be used to create value for equity holders.
Unlevered Free Cash Flow's supposed to tell us how much cash's available for:
Paying down debt
Returning value to equity holders
Expanding the business
Improving the company's financial resilience (for example, by keeping the cash in the bank instead of spending it)
But, it understates the full amount of cash that was available for those purposes because hidden discretionary spending has already been subtracted out.
Levered Free Cash Flow's supposed to tell us how much cash's available for the last three items on the list.
It, too, understates the full amount of cash that was available for those purposes. As a result, we don't know (1) the full amount management could've paid out as dividends and (2) what they spent it on instead.
This highlights the general issue: Not separating out discretionary spending reduces visibility into how management's using the company's cash flow.
The good thing is that this results in conservative estimates of cash flow. It gives us some margin of safety when using them to value a business.
The bad side's that it:
Limits transparency: Combining non-discretionary and discretionary spending makes it difficult to see how much of each occurred.
Reduces accountability: The inability to easily see discretionary spending reduces the pressure to justify the decisions behind that spending.
Leads to suboptimal decisions: The mixed meaning of CAPEX and understatement of FCF, UFCF, and LFCF make it difficult to optimize decisions that depend on them.
We've been talking about discretionary spending a lot.
The fancy for name discretionary spending is: Capital Allocation.
Capital: Financial assets available to fund business activities
Allocation: Assignment to a specific purpose
So, our views of both cash flow and Capital Allocation are a bit skewed.
Hopefully, the management team's internal views are better.
If not, it's likely to lead to poor Capital Allocation decisions.
This is the main point Secret CFO makes in the Maintainable Free Cash Flow article.
Solution: Maintainable Free Cash Flow (MFCF)
Secret CFO proposes a solution that's conceptually straight-forward:
Separate out discretionary and non-discretionary spending.
Why's that valuable?
Because doing so:
Increases transparency: It provides more visibility intowhat management's (intentionally or unintentionally) doing with the business's cash flow.
Increases accountability: Visibility results in decision-makers being held accountable for their decisions.
Empowers team members to make better decisions: Clarity on what's a Capital Allocation decision and what's not helps employees at all levels align decisions with broader strategy.
The article walks through an example that nicely illustrates the concept.
Here's how Maintainable Free Cash Flow's defined in the article:
EBITDA - Stock-based Compensation + Research and Development for Growth + Discretionary Marketing Investment -------------------------------------- EBITDA After Restatements - Interest on Debt - Tax on Profits - Movement in Working Capital - Maintenance Capital Expenditures -------------------------------------- Maintainable Free Cash Flow (MFCF) - Research and Development for Growth - Discretionary Marketing Investment - Growth Capital Expenditures -------------------------------------- MFCF After Internal Capital Allocations
Reminder: EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. (See the cash flow article if you need a refresh.)
"EBITDA After Restatements" is a type of Adjusted EBITDA [1].
It's EBITDA before spending that qualifies as Capital Allocation.
That is, it’s Earnings Before Interest, Taxes, Depreciation, Amortization, and Capital Allocation.
Notice that the MFCF calculations start by subtracting Stock-based Compensation from EBITDA.
If you recall from the income article, the cost of Stock-based Compensation's already accounted for in Net Income.
Since the "Earnings" in EBITDA refers to Net Income, that means it's also already accounted for in EBITDA.
So:
Why's it being subtracted out again?
Given that it's a non-cash expense, why's it being counted as a cash flow at all?
Answers:
I think Secret CFO's treating EBITDA as not yet accounting for Stock-based Compensation. From that perspective, the subtraction done here would be the first and only time it's being accounted for.
They're treating Stock-based Compensation as a cash flow because that allows its impact to flow through dependent calculations.
Note: The cash flow article provides reasons for treating Stock-based Compensation as a cash flow even though it's a non-cash expense. For more info, see the article's section on Unlevered Free Cash Flow.
We go from “EBITDA After Restatements” to “Maintainable Free Cash Flow” by accounting for non-discretionary flows of cash.
Then, we go from “Maintainable Free Cash Flow” to “MFCF After Internal Capital Allocations” by accounting for the flows cash that qualify as Capital Allocation.
Maintainable Free Cash Flow in familiar terms
Let's look at MFCF in more familiar contexts.
Keep in mind that our goal is to get more insight into the business's Capital Allocation (discretionary spending) decisions.
In simplified terms, let's refer to Capital Allocation spending as discretionary spending. And business-maintenance spending as non-discretionary spending.
Let's start by defining CAPEX as [2, 3]:
CAPEX = Maintenance CAPEX + Growth CAPEX
Then, let's update the formulas to:
View EBITDA as already accounting for Stock-based Compensation
Normalize the names used
EBITDA + Discretionary Research and Development + Discretionary Marketing -------------------------------------- EBITDA After Restatements - Interest Expenses - Income Taxes - Change in Working Capital - Maintenance CAPEX -------------------------------------- Maintainable Free Cash Flow
Next, let's:
1. Combine the discretionary spending under a single name and call it "Discretionary Operational Investment"
2. Rename "EBITDA After Restatements" to EBITDAC (Earnings Before Interest, Taxes, Depreciation, Amortization, and Capital Allocation)
EBITDA + Discretionary Operational Investment -------------------------------------- EBITDAC - Interest Expenses - Income Taxes - Change in Working Capital - Maintenance CAPEX -------------------------------------- Maintainable Free Cash Flow
So, the formulas that leaves us with are:
EBITDAC = EBITDA + Discretionary Operational Investment
MFCF = EBITDAC
- Interest Expenses
- Income Taxes
- Change in Working Capital
- Maintenance CAPEX
MFCF = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
In Secret CFO’s article, they:
Don't adjust Interest Expenses by debt used to fund growth assets
Don't adjust Income Taxes for the amount of income represented by difference between EBITDAC and actual taxable income
This makes sense because:
Separating out Interest Expenses would, at best, require arbitrary guesses about what portion of what funding was for what spending 😵💫
Adjusting taxes creates a big mess because it:
Requires separating out the portion of Depreciation and Amortization associated with growth assets
Requires figuring out how much of taxes are attributable to discretionary operational spending
Bleeds into downstream calculations in increasingly complex ways
Trust me when I say the benefit's of trying to do the above aren’t worth the effort. I tried. 🥴
So, let’s just keep in mind that Maintainable Free Cash Flow:
Doesn't separate out interest expenses associated with funding the purchase of growth assets
Doesn't separate out the tax impact of spending on growth
Relation to Operating Cash Flow (OCF)
If you're familiar with Operating Cash Flow, you might've noticed Maintainable Free Cash Flow is very similar.
As a reminder, Operating Cash Flow is: The cash generated by a business’s operating activities.
While, Maintainable Free Cash Flow is: The cash generated by a business’s operating activities before any investments in growth.
Let's see how to get Operating Cash Flow from Maintainable Free Cash Flow:
MFCF = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
Net Income = MFCF
- Depreciation
- Amortization
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Change in Working Capital
Operating Cash Flow = Net Income
+ Depreciation
+ Amortization
+ Other Non-cash Expenses
- Non-cash Income
- Change in Working Capital
Operating Cash Flow = MFCF
- Depreciation
- Amortization
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Change in Working Capital
+ Depreciation
+ Amortization
+ Other Non-cash Expenses
- Non-cash Income
- Change in Working Capital
Operating Cash Flow = MFCF
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Other Non-cash Expenses
- Non-cash Income
Note: Other Non-cash Expenses refers to all Non-cash Expense, except Depreciation and Amortization.
So, to go from Maintainable Free Cash Flow to Operating Cash Flow, we:
Restore the impact of spending on growth
Remove the Maintenance CAPEX spending (Operating Cash Flow is pre-CAPEX)
Remove the impact of Non-cash Expenses and Non-cash Income (including the cost of Stock-based Compensation)
Here's what they look like in sequence:
Net Income + Depreciation + Amortization + Discretionary Operational Investment - Maintenance CAPEX - Change in Working Capital -------------------------------------- Maintainable Free Cash Flow - Discretionary Operational Investment + Maintenance CAPEX + Other Non-cash Expenses - Non-cash Income -------------------------------------- Operating Cash Flow
Relation to Free Cash Flow (FCF)
As a reminder, Free Cash Flow is: The cash generated by a business's operating activities after removing the spending required to sustain those activities.
Let's see how to get Free Cash Flow from Maintainable Free Cash Flow:
MFCF = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
FCF = Operational Cash Flow - OPEX
FCF = MFCF
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Other Non-cash Expenses
- Non-cash Income
- OPEX
FCF = MFCF
- Discretionary Operational Investment
- Growth CAPEX
+ Other Non-cash Expenses
- Non-cash Income
Note: Other Non-cash Expenses refers to all Non-cash Expenses, except Depreciation and Amortization.
So, to go from Maintainable Free Cash Flow to Free Cash Flow, we:
Account for discretionary spending on growth (CAPEX and operational investments)
Reverse Other Non-cash Expenses and Non-cash Income
Note: Free Cash Flow has a well-defined, standard definition. In that definition, all Non-cash Expenses and Non-cash Income are excluded. So, despite our thoughts on treating Stock-based Compensation like a cash expense, we uphold the standard definition and reverse all non-cash expenses, including Stock-based Compensation here. In practice, we can adjust our calculations to treat Stock-based Compensation as we see fit.
Here's what it looks like in sequence:
Net Income + Depreciation + Amortization + Discretionary Operational Investment - Maintenance CAPEX - Change in Working Capital -------------------------------------- Maintainable Free Cash Flow - Discretionary Operational Investment - Growth CAPEX + Other Non-cash Expenses - Non-cash Income -------------------------------------- Free Cash Flow
Free Cash Flow is directly connected to Operating Cash Flow:
Free Cash Flow = Operating Cash Flow - CAPEX
So, it's informative to look at how all three of these metrics relate: Maintainable Free Cash Flow, Operating Cash Flow, and Free Cash Flow.
Here's what they look like in sequence:
Net Income + Depreciation + Amortization + Discretionary Operational Investment - Maintenance CAPEX - Change in Working Capital -------------------------------------- Maintainable Free Cash Flow - Discretionary Operational Investment + Maintenance CAPEX + Other Non-cash Expenses - Non-cash Income -------------------------------------- Operating Cash Flow - CAPEX -------------------------------------- Free Cash Flow
And here's what they look like with OCF and MFCF side-by-side:
Net Income Net Income
+ Depreciation + Depreciation
+ Amortization + Amortization
+ Discretionary Operational Investment
+ Other Non-cash Expenses
- Non-cash Income
- Change in Working Capital - Change in Working Capital
- Maintenance CAPEX
-------------------------------------- --------------------------------------
Operating Cash Flow Maintainable Free Cash Flow
+ Other Non-cash Expenses
- Non-cash Income
- Discretionary Operational Investment
- Maintenance CAPEX
- Growth CAPEX - Growth CAPEX
-------------------------------------- --------------------------------------
Free Cash Flow Free Cash Flow
Relation to Unlevered Free Cash Flow (UFCF)
As a reminder, Unlevered Free Cash Flow is: The cash generated by a business's operating activities, excluding the impact of its Capital Structure.
Let's look at how to get Unlevered Free Cash Flow from Maintainable Free Cash Flow:
MFCF = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
Change in Working Capital = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- MFCF
UFCF = EBIT
- (EBIT × Tax Rate)
+ Depreciation
+ Amortization
- CAPEX
- Change in Working Capital
UFCF = EBIT
- (EBIT × Tax Rate)
+ Depreciation
+ Amortization
- CAPEX
- Net Income
- Depreciation
- Amortization
- Discretionary Operational Investment
+ Maintenance CAPEX
+ MFCF
UFCF = MFCF
+ EBIT
- (EBIT × Tax Rate)
- Net Income
- Growth CAPEX
- Discretionary Operational Investment
UFCF = MFCF
+ (Net Income + Interest Expenses + Income Taxes)
- (EBIT × Tax Rate)
- Net Income
- Growth CAPEX
- Discretionary Operational Investment
UFCF = MFCF
+ Interest Expenses
+ Income Taxes
- (EBIT × Tax Rate)
- Growth CAPEX
- Discretionary Operational Investment
So, to go from Maintainable Free Cash Flow to Unlevered Free Cash Flow, we:
Reverse Interest Expenses and Income Taxes
Apply EBIT-based income taxes
Account for discretionary spending on growth (CAPEX and operational investments)
Here's what it looks like in sequence:
Net Income + Depreciation + Amortization + Discretionary Operational Investment - Maintenance CAPEX - Change in Working Capital -------------------------------------- Maintainable Free Cash Flow + Interest Expenses + Income Taxes - (EBIT × Tax Rate) - Growth CAPEX - Discretionary Operational Investment -------------------------------------- Unlevered Free Cash Flow
Relation to Levered Free Cash Flow (LFCF)
As a reminder, Levered Free Cash Flow is: The cash generated by a business's operating activities that's available to return value to equity holders.
We could also describe it as: The cash generated by a business's operating activities prior to Capital Allocation decisions.
Our focus on Capital Allocation makes this is a particularly interesting relationship!
Let's look at how to get Levered Free Cash Flow from Maintainable Free Cash Flow:
MFCF = Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
Net Income = MFCF
- Depreciation
- Amortization
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Change in Working Capital
LFCF = Net Income
+ Depreciation
+ Amortization
− CAPEX
− Change in Working Capital
− Repayments of Debt Principal
+ Newly Issued Debt
LFCF = MFCF
- Depreciation
- Amortization
- Discretionary Operational Investment
+ Maintenance CAPEX
+ Change in Working Capital
+ Depreciation
+ Amortization
− CAPEX
− Change in Working Capital
− Repayments of Debt Principal
+ Newly Issued Debt
LFCF = MFCF
- Discretionary Operational Investment
− Growth CAPEX
− Repayments of Debt Principal
+ Newly Issued Debt
So, to go from Maintainable Free Cash Flow to Levered Free Cash Flow, we:
Account for discretionary spending on growth (it's from previous Capital Allocation decisions, so not available for new Capital Allocation decisions)
Account for repayment and issuance of debt
In sequence, this looks like:
Net Income + Depreciation + Amortization + Discretionary Operational Investment - Maintenance CAPEX - Change in Working Capital -------------------------------------- Maintainable Free Cash Flow - Discretionary Operational Investment − Growth CAPEX − Repayments of Debt Principal + Newly Issued Debt -------------------------------------- Levered Free Cash Flow
Another view of the relations
Here's another perspective on these relationships:
Net Income
+ Depreciation
+ Amortization
+ Discretionary Operational Investment
- Maintenance CAPEX
- Change in Working Capital
--------------------------------------
Maintainable Free Cash Flow
- Discretionary Operational Investment - Discretionary Operational Investment - Discretionary Operational Investment
− Growth CAPEX - Growth CAPEX − Growth CAPEX
+ Other Non-cash Expenses
- Non-cash Income
+ Interest Expenses
+ Income Taxes
- (EBIT × Tax Rate)
− Repayments of Debt Principal
+ Newly Issued Debt
-------------------------------------- -------------------------------------- --------------------------------------
Free Cash Flow Unlevered Free Cash Flow Levered Free Cash Flow
Note: Other Non-cash Expenses refers to all Non-cash Expenses, except Depreciation and Amortization.
In practical terms
How can we apply the idea of Maintainable Free Cash Flow in practical terms?
To be honest, I don't want to get too far ahead of myself here.
Personally, I don't yet have enough skill for it to make sense to reach much beyond low-hanging fruit.
And, I don't think figuring out how to calculate MFCF from public financial statements is low-hanging fruit.
The objective of Secret CFO's article is to help management teams avoid bad spending decisions. They can do this by integrating Maintainable Free Cash Flow into internal metrics.
It's not meant to give investors a new magic metric.
That said, there's a lot of literature on two closely related topics:
Maintenance CAPEX vs Growth CAPEX
Return on Invested Capital (ROIC)
Here're a couple quality resources on Maintenance CAPEX vs Growth CAPEX:
Explaining the Growth Capex Formula with an Easy Example. By Andrew Sather. Sather Research.
Maintenance Capital Expenditures: The Easy Way to Calculate It (With Calculator). By Dave Ahern. Sather Research.
Return on Invested Capital is a measure of how good a company is at generating returns on the cash it uses to fund its business.
Maximizing returns is a result of good Capital Allocation.
Here're a couple quality resources on the topic:
Decoding ROIC: Analyzing Returns on Invested Capital for Business Success. FindingCompounders.
Note: This is a simple overview that's an easy, 8-minute read.
How to Calculate and Analyze Return on Invested Capital. StableBread.
The Saber Capital Management Series on ROIC:
Importance of ROIC Part 1: Compounders and Cheap Stocks. By John Huber. Saber Capital Management.
Importance of ROIC Part 2: Compounders and Cheap Stocks. By John Huber. Saber Capital Management.
Importance of ROIC Part 3: Compounding and Reinvestment. By John Huber. Saber Capital Management.
Importance of ROIC Part 4: The Math of Compounding. By John Huber. Saber Capital Management.
Importance of ROIC Part 5: A Glance at the Last 42 Years of Wells Fargo. By John Huber. Saber Capital Management.
Importance of ROIC: “Reinvestment” vs “Legacy” Moats. By John Huber. Saber Capital Management.
Calculating the Return on Incremental Capital Investments. By John Huber. Saber Capital Management.
Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications. By Aswath Damodaran. Stern School of Business.
Note: This guide is deep, technical, and thorough.
Meanwhile, let's keep in the back of our mind that there's a difference between spending on maintenance and spending on growth.
Simply being conscientious of this should help draw our attention to the right things.
Conclusion
We won't find Maintainable Free Cash Flow in annual or quarterly reports of any company.
But, the idea gets us thinking about Capital Allocation.
And, that's important.
Capital Allocation decisions are share holder value decisions.
Consistent, skillful decisions about what to do with the cash a business generates can be the difference between average returns and 10x returns.
So, even though Maintainable Free Cash Flow isn't explicitly reported, we should look for evidence of a company's Capital Allocation decisions.
In fact, the fact that it's not reported is more reason to do so.
If you haven't already, I'd encourage reading Secret CFO's Maintainable Free Cash Flow article.
I'd also recommend checking out another of CFO Secrets article focused specifically on Capital Allocation.
And now for something completely different
I've been listening to The Snowball: Warren Buffett and the Business of Life by Alice Schroeder.
I'm about half-way through and I'm completely absorbed. Apart from his investing track record, Buffet has a fascinating life story.
Interesting tidbit: Did you know Buffet repeatedly stole golf balls from a department store as a child?
The story's well-told and the narration of the audio book's engaging and easy to listen to.
I think it's well worth checking out if you're interested in what makes Buffet Buffet.
Even if you're not particularly interested in Buffet the investor, you might still enjoy the story of Buffet the person.
References
Noted references:
Adjusted EBITDA. Wall Street Prep.
Andrew Sather. Explaining the Growth Capex Formula with an Easy Example. Sather Research. Retrieved 2024-09-16.
Dave Ahern. Maintenance Capital Expenditures: The Easy Way to Calculate It (With Calculator). Sather Research. Retrieved 2024-09-16.
Additional references:
Secret CFO. M****** F****** Cashflow: Cash generation vs capital allocation. CFO Secrets.
Tim Vipond. Capital Expenditure (CapEx). CFI Education. Retrieved 2024-09-16.
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