Cash Flow Analysis & Free Cash Flow

Learning objectives

By the end you can:

1. Read any cash flow statement as an analyst in ten minutes: restate it to a single convention (interest, leases), bridge net income to CFO, and say which of the five quality tiers is actually generating the cash.
2. Compute and interpret the conversion ratios: CFO/NI and CFO/EBITDA over multi-year windows, with benchmark ranges, the anatomy of the gap, and the cross-standard restatements that make them comparable.
3. Build free cash flow properly: FCF = CFO − capex, with the four definitional decisions made explicit (which capex, disposals, lease principal, interest classification), and defend your definition.
4. Split capex into maintenance and growth three ways (the depreciation proxy, Greenwald's sales-linked method, and disclosure/unit methods), then triangulate to a defensible range.
5. Compute Buffett's owner earnings and reconcile it to FCF: state when the two diverge, in which direction, and what each is for.
6. Read capex/depreciation as a life-cycle and aggression signal, including the inflation adjustment and the capitalization red flag it hands to M2.06.
7. Handle stock-based compensation honestly: show with numbers why "FCF" that ignores SBC dilution overstates owner returns, and apply both correction methods.
8. Classify any company into one of the four cash-flow personalities (compounder, capex monster, working-capital sink, financial-engineering case), name the follow-up question each personality demands, and build a ten-year cash walk (where every rupee or dollar of CFO went) in under an hour from public filings.

Prerequisites & connections

Builds on. M1.04: you can build a CFS and you know the classification map, meaning US GAAP interest paid in CFO, Ind AS interest paid in CFF and interest received in CFI, lease principal in CFF under IFRS 16/Ind AS 116. The work here attaches money to those differences. Add M1.05 (the three-statement linkage; the NI→CFO bridge is your accruals X-ray) and M1.08–M1.09 (leases, SBC mechanics: expense, add-back, dilution). Then the ratio layer: M2.01 (margins, where EBITDA arrives as a numerator to be distrusted) and M2.02 (working capital: DSO/DIO/DPO and ΔWC ≈ WC% of sales × Δrevenue, the arithmetic of the working-capital sink). Last, M2.03, because negative FCF is judged by the return on the capital it funds, which is ROIC and ROIIC.

Feeds forward. M2.05 benchmarks these ratios across peers and time. M2.06–M2.07 turn every divergence flag raised here into a named shenanigan with a detection test (payables stretch, factoring, capitalization games, Sloan accruals). M3.04 rebuilds cash flow formally as FCFF/FCFE for valuation, and the definitional discipline you learn here is why you will never mix a levered cash flow with an unlevered discount rate. M3.07 grades a decade of capital allocation, where the cash walk is its evidence table. M4.04–M4.06 read durable FCF conversion as moat evidence. M8.02–M8.03: teardown question 7 (cash conversion) and the deep-dive workbook's ten-year CFO/capex/FCF rows are this skill, executed at speed, forever.

Profit is an opinion about the period. Cash is a fact about the bank account. The work ahead is to reconcile the two, decide how much of the cash is durable, subtract what the business must spend to stay alive, and follow what remains until you can see the owners' money — or see that there isn't any.

4.1 Profit is an opinion, cash is a fact: almost

Start with the oldest line in the trade: revenue is vanity, profit is sanity, cash is reality. The three differ mechanically, because accrual accounting books economic events when they happen and not when cash moves. A sale on 90-day credit is revenue today, cash next quarter. Depreciation is an expense today for cash spent years ago.

So the gap between profit and cash is not a scandal. It is the design. The scandal, when there is one, lives in the pattern of the gap.

Why analysts trust the cash flow statement more than the P&L, in one argument: net income is the sum of dozens of estimates, among them revenue recognition timing, provision sizing, depreciation lives, impairment judgments, deferred tax positions. Each estimate is a small dial management can turn. CFO starts from that estimated number and then reverses every estimate out of it, replacing accruals with what actually moved through the bank. Fewer dials. A company can book a fictitious sale with a journal entry; making fictitious cash arrive requires an accomplice or a crime.