1. The importance of the operating cycle

Let’s take the example of a greengrocer, who is “cashing up” one evening. What does he find? Firstly, he sees how much he spent in cash at the wholesale market in the morning and then the cash proceeds from fruit and vegetable sales during the day. If we assume that the greengrocer sold all the produce he bought in the morning at a mark-up, then the balance of receipts and payments for the day will be a cash surplus.

Unfortunately, things are usually more complicated in practice. It’s rare that all the goods bought in the morning are sold by the evening, especially in the case of a manufacturing business.

A company processes raw materials as part of an operating cycle, the length of which varies tremendously, from a day in the newspaper sector to seven years in the cognac sector. There is, then, a time lag between purchases of raw materials and the sale of the corresponding finished goods.

This time lag is not the only complicating factor. It is unusual for companies to buy and sell in cash. Usually, their suppliers grant them extended payment periods, and they in turn grant their customers extended payment periods. The money received during the day does not necessarily come from sales made on the same day.

As a result of customer credit,² supplier credit³ and the time it takes to manufacture and sell products or services, the operating cycle of each and every company spans a certain period, leading to timing differences between operating outflows and the corresponding operating inflows.

Each business has its own operating cycle of a certain length that, from a cash flow standpoint, may lead to positive or negative cash flows at different times. Operating outflows and inflows from different cycles are analysed by period, e.g. by month or by year. The balance of these flows is called operating cash flow. Operating cash flow reflects the cash flows generated by operations during a given period.

In concrete terms, operating cash flow represents the cash flow generated by the company’s day-to-day operations. Returning to our initial example of an individual looking at his bank statement, it represents the difference between the receipts and normal outgoings, such as food, electricity and car maintenance costs.

Naturally, unless there is a major timing difference caused by some unusual circumstances (start-up period of a business, very strong growth, very strong seasonal fluctuations), the balance of operating receipts and payments should be positive.

Readers with accounting knowledge will note that operating cash flow is independent of any accounting policies, which makes sense since it relates only to cash flows. More specifically:

• neither the company’s depreciation and provisioning policy,
• nor its inventory valuation method,
• nor the techniques used to defer costs over several periods have any impact on the figure.

However, the concept is affected by decisions about how to classify payments between investment and operating outlays, as we will now examine more closely.

2. Investment and operating outflows

Let’s return to the example of our greengrocer, who now decides to add frozen food to his business.

The operating cycle will no longer be the same. The greengrocer may, for instance, begin receiving deliveries once a week only and will therefore have to run much larger inventories. Admittedly, the impact of the longer operating cycle due to much larger inventories may be offset by larger credit from his suppliers. The key point here is to recognise that the operating cycle will change.

The operating cycle is different for each business and, generally speaking, the more sophisticated the end product, the longer the operating cycle.

But most importantly, before he can start up this new activity, our greengrocer needs to invest in a chest freezer.

What difference is there between this investment and operating outlays?

The outlay on the chest freezer seems to be a prerequisite. It forms the basis for a new activity, the success of which is unknown. It appears to carry higher risks and will be beneficial only if overall operating cash flow generated by the greengrocer increases. Lastly, investments are carried out from a long-term perspective and have a longer life than that of the operating cycle. Indeed, they last for several operating cycles, even if they do not last forever given the fast pace of technological progress.

This justifies the distinction, from a cash flow perspective, between operating and investment outflows.

Normal outflows, from an individual’s perspective, differ from an investment outflow in that they afford enjoyment, whereas investment represents abstinence. As we will see, this type of decision represents one of the vital underpinnings of finance. Only the very puritanically minded would take more pleasure from buying a microwave than from spending the same amount of money at a restaurant! Only one of these choices can be an investment and the other an ordinary outflow. So what purpose do investments serve? Investment is worthwhile only if the decision to forego normal spending, which gives instant pleasure, will subsequently lead to greater gratification.

This is the definition of the return on investment (be it industrial or financial) from a cash flow standpoint. We will use this definition throughout this book.

The impact of investment outlays is spread over several operating cycles. Financially, capital expenditures are worthwhile only if inflows generated thanks to these expenditures exceed the outflows by an amount yielding at least the return on investment expected by the investor.

Note also that a company may sell some assets in which it has invested in the past. For instance, our greengrocer may decide after several years to trade in his freezer for a larger model. The proceeds would also be part of the investment cycle.

3. Free cash flow

Before-tax free cash flow is defined as the difference between operating cash flow and capital expenditure net of fixed asset disposals.

As we shall see in Sections II and III of this book, free cash flow can be calculated before or after tax. It also forms the basis for the most important valuation technique. Operating cash flow is a concept that depends on how expenditure is classified between operating and investment outlays. Since this distinction is not always clear-cut, operating cash flow is not widely used in practice, with free cash flow being far more popular. If free cash flow turns negative, then additional financial resources will have to be raised to cover the company’s cash flow requirements.