Does Growth Require Cash?

A new metric gauges the amount of free cash flow companies can generate as they grow.
David KatzMay 18, 2011

Chuck Mulford dates the birth of his brainchild, a just-launched metric he calls the Free Cash Profile, to a conversation he had about 20 years ago with the chief executive officer of a very small company called Information Resource Engineering. Mulford, a Georgia Tech accounting professor whose passion is investing, saw IRE as a potentially good stock to buy.

Looking for small caps to invest in years before the Internet blossomed, he liked the company’s assets and the big accounts it was signing up. Possessing the software for transmitting sensitive information over phone lines, IRE could encrypt data when it was sent and decrypt it when it was received. One thing that bothered Mulford about the company, however, was the question of how it would finance the large amount of growth it was projecting.

In those days, the conventional wisdom was that growth ate up cash. Since IRE didn’t have much of it, Mulford asked Anthony A. Caputo, the company’s CEO: If the company ran into debt problems, how would you service that debt?

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Caputo’s response, Mulford recalls, was that IRE would finance its growth internally. The faster it grew, the more cash it would generate. And indeed, IRE did grow, proceeding to offer a very successful software product called SafeNet, which later became the company’s name. (Caputo was forced to step down in 2006 during an options-backdating scandal.)

Caputo’s answer triggered an “Aha!” moment for Mulford. “I realized that my whole paradigm for understanding cash flow was inadequate,” he says. Despite the conventional wisdom, it was at least theoretically possible that a company could generate enough cash to finance its own growth as it was growing. Or even a great deal more than that.

It took years, but Mulford, director of the Georgia Tech Financial Analysis Lab, molded his thinking into a single predictive metric that he believes can suggest a company’s ability to generate or consume free cash flow as it grows. In a recent study of 44 nonfinancial industries, including 2,290 companies with annual revenues of more than $100 million, the lab’s researchers found a median Free Cash Profile of 4.95%. In simplest terms, for every dollar of sales growth, most companies can be expected to throw off about 5 cents of free cash flow.

To calculate a company’s Free Cash Profile, Mulford starts with what he calls its Core Cash Profile. The Core Cash Profile measures a company’s capacity to generate core operating cash flow as it grows. He gets to that by subtracting the percentage of revenue represented by operating working capital (current assets minus current liabilities) from the percentage of revenue represented by operating cushion (operating profit before noncash depreciation and amortization).

In essence, the Core Cash Flow Profile represents the amount of core operating cash flow that can be expected for any measured amount of growth, assuming that a firm’s current mix of operating cushion and operating working capital stays the same. 

To arrive at a company’s Free Cash Profile, Mulford subtracts the company’s percentages of revenue represented by taxes paid and capital expenditures from the Core Cash Profile. By eliminating taxes and capex — two expenditures typically expected to grow as sales grow — Mulford seeks a way to focus exclusively on the way growth affects a company’s free cash flow. Forecasting a company’s revenue is a familiar activity among analysts; predicting free cash flow is not.

The Free Cash Profile assumes that a firm’s current mix of operating cushion, operating working capital, capital expenditures, and taxes paid, all as percentages of revenue, remains unchanged. That assumption “helps anticipate future cash flows by assuming that things like margins, receivables requirements, and inventory requirements are not going to change,” says Mulford. “A good starting point for any forecast is a steady state.”

Despite the lab’s finding that the typical company throws off at least some free cash flow as it grows, not every company can expect to fund its own growth with the cash that growth generates. Eighteen industries, or 40% of the sample, had negative Free Cash Profiles. But even in those industries, there are many firms with positive profiles.

“The firms with positive Free Cash Profiles enjoy higher operating cushions and are more adept at managing operating working capital and limiting capital spending than firms with negative profiles,” says the lab’s report.

Looking at the current scene, Mulford has particular admiration for Apple. The company, he observes, has generated so much cash as it has grown that it’s drawn complaints from investors wanting some of that cash back. Recently, Google has shown to be particularly adept at generating cash as it grows, just as the slower-growing Microsoft once excelled. But unlike those two companies, Apple is a manufacturer with all the working capital requirements implied by that — yet it’s still able to amass a huge cash hoard.

If they benchmark their companies’ Free Cash Profiles against those of their peers, CFOs can gauge where their companies are likely to stand in the eyes of the sharpest investors, Mulford says. “If you look at the investments that Warren Buffett likes, they tend to be companies with positive Free Cash Profiles, he says. “Not that he’s used that term, but he knows how to find investments that can generate cash and grow at the same time.”