This is CFO Secrets. The Saturday morning newsletter that helps your cash flow free like the ocean.

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In Today’s Email:

• 💸 A very special cash metric

• 🦇 Ben ‘Double Entry’ Affleck

• 🚽 Community Adjusted Free Cash Flow

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A WORD FROM THIS SEASON’S SPONSOR…

THE DEEP DIVE

Maintainable Free Cashflow; Cash Generation vs Capital Allocation

This is the second week in an 8 week season covering how to build a culture of cashflow obsession in your business.

“How dare you” bellowed the CEO.

Not the reaction the Divisional President was expecting.

And I had some sympathy.

He’d just closed out the year with his division beating his EBIT budget by $7m.

The best performance across the whole Business by a mile.

But the CEO was angry that the DP had authorized an unbudgeted $3m advertising spend, right at the end of the year.

The DP got on the defensive.

“What’s the problem? We beat our budget. We beat our latest forecast, even after this spend? It’s inside my authority limit. I’m investing in a stronger sales line for next year. I thought you’d be pleased… But it sounds like you needed my numbers to prop up yours.”

He wasn’t wrong, but this was brave. This CEO was the most volatile I’d worked with. You never knew what you were going to get.

I was in corporate FP&A at the time, so I sat back and enjoyed the fireworks. Here we go!

After a bunch of colorful language that I won’t repeat, the CEO said this:

“You are missing the point. Worse than that. You don’t understand what you are here to do. You don’t understand your f*cking job.”

The CEO explained that a discretionary spend like this was a capital allocation.

And that Divisional Presidents did not exist to make capital allocation decisions. DPs existed to fill the Corporate coffers with cash generation from their businesses.

And what if they have the luxury of generating more cash than expected?

Then the DP didn’t get to make the decision of what to do with that. That decision belonged to the CEO (with the CFOs support)

The DP could make their case and present investment opportunities. But it was for the CEO to make the decision.

He went on …

Capital allocation decisions are about trade offs. Do we invest in capex? Pay a dividend? Pay down debt? Buy back shares? Take a punt on unplanned advertising?

Capital allocation decisions can only be taken by someone who can see the risk and return profile of all alternatives.

The DP backed down: “I’d not thought about a P&L investment in that way before.”

It was a fair point; neither had I.

The CEO implied that we should evaluate this sort of discretionary spend like a capex decision.

It was an interesting re-frame for me.

Years later, I read the brilliant Outsiders by William Thorndike. A book which told the story of eight CEOs who achieved remarkable returns.

In the book Thorndike said “Capital allocation is the most important job of the CEO.”

This reminded me of the quote in Warren Buffett’s 1987 letter to shareholders:

Those two quotes together brought me back to the experience with the CEO the years before.

I was now in my first CFO role, and I didn’t want to be described as being ‘unskilled in capital allocation.’

I decided I needed to change how I looked at cashflows. And then reframe the lens through which the whole business looked at cashflow.

This in turn would change the KPIs used for cashflow, the reporting cadence, bonus targets. Everything.

I had to think about internal capital allocation in a more expansive way.

One that went beyond the simplistic view that GAAP encouraged.

It was from here that I developed the measure Maintainable Free Cashflow.

It’s sole purpose to allocate responsibility for cashflow items to the right place. The right owners in the business.

So, we are going to first principles on cashflow this week.

And we are going to get hyper technical in this post, so strap in.

If you want something simpler to digest as a summary, read this tweet thread first:

Anyway.

Cashflow First Principles

Cashflow is the difference between the cash balance at two different dates.

If you had a cash balance at the start of a period of $20, and a balance at the end of the period of $80. Then your cashflow was $60.

On its own, this tells you nothing.

Let’s take Business A & Business B who both had a cashflow of $60 under this definition.

Assume:

• Business A raised $100 of debt during the period.

• Business B paid $100 of dividends during the period.

If Business A only generated $60 of cashflow despite raising $100 of new money from lenders. Then, underlying, it burned $40 of cashflow.

If Business B generated $60 of cashflow despite paying $100 of dividends. Then, underlying, it generated $160 of cashflow.

Very different cashflow profiles, both with the same total cashflow movement.

This is where the term free cashflow comes from.

Free Cashflow

Free Cashflow looks at cashflow before accounting for amounts paid or received to and from investors.

What is the generated cashflow that is ‘free’ to those investors. i.e. what is the business itself actually producing in terms of cashflow.

The question then comes … free to which investors?

FCFE and FCFF

This is where the two commonly used parallel definitions come from:

• Free Cashflow to Equity (FCFE)

• Free Cashflow to the Firm (FCFF)

FCFE asks what cashflow is free to shareholders in the business.

FCFE = Cashflows before any dividends, share buybacks or new equity issues. But after all debt repayments and interest get made.

FCFF asks what cashflow is free to all investors in the business (i.e. shareholders and lenders)

FCFF = Cashflows before any dividends, share buybacks, new equity issues, interest payments, new debt or debt repayments.

So the difference between FCFE and FCFF is any payments to or from lenders.

And this can get funky if you have many layers of debt, with different structural priority. What cashflow is ‘free’ to one lender, may not be free to another.

Free Cashflow is cool again

For the last decade founders got celebrated for their capital raises. Raising a Series Q megaround to fund working capital for a 7 year old startup ‘reimagining mustard home delivery’ is something to be proud of. Apparently.

A ZIRP phenomenon if ever there was one.

That era is dead.

Debt and equity funding got more expensive by 500-600 basis points a year. Which means its cool to fund your growth from your own business operations again.

In short… Free Cashflow is back baby.

About f*cking time.

What is Maintainable Free Cashflow?

M****** F***** Cashflow for short. Or MFCF for even shorter.

At its core, MFCF is just a different sub-total inside the cashflow statement.

But then all KPIs are just a sub-total of something.

MFCF is your key to getting a complex business to drive cashflow like their lives depend on it.

So let’s define MFCF in the context of the cashflow statement.

First in principle. Then in detail.

What are the principles of MFCF?

We have some cashflows that sit ‘above the line’ in MFCF, i.e. part of the MFCF measure.

And some cashflows that sit ‘below the line', i.e. excluded from the MFCF calculation.

Above the line cashflows (those included in MFCF) are cash generations from existing operations.

Below the line cashflows (excluded from MFCF) are allocations of capital.

The latter does not only mean capital allocation to investors. But also capital that is being reinvested or recycled back into the business.

This is what makes it different to a regular Free Cash Flow calculation.

It takes some cashflows that are oftentimes treated like 'operational' cashflows. And reclassifies them to treat them more like financing or investing cashflows.

Example of internal capital allocations:

• The $3m advertising punt in the case this post started with.

• Capital to build a new factory

• Research and Development to enter new markets

Now we are being intentional about what cashflows sit where. Allowing you to divide ownership for cashflows into the right areas. And then drive them harder.

The cashflows you have defined as being part of MFCF can now get allocated directly to operations. Where they get driven. More on how you do this next week.

Cashflows outside of MFCF get controlled centrally under the watch of the CEO and CFO. Coordinated through the FP&A / treasury teams.

Now, you can ensure there are no capital allocation decisions by stealth taken by business operations.

Remember cashflow isn't generated by nerds in spreadsheets (like me and you).

Cashflow gets generated by real people who make and sell real things.

The net result is this:

1. It gives business operators clear mandate to focus on execution. And execution only.

2. It stops suboptimal capital allocation decisions getting made in a decentralized way.

So that’s the principle of the definition of MFCF.

Also the easy bit.

How exactly do we define it?

Defining MFCF technically

Two quick notes before we go here.

1. We are about to leave GAAP cashflow presentation behind. And that is fine. We are talking about a KPI here, and you can define those in whatever way suits you. You need to reconcile it back to GAAP presentation, but I’ll assume you are big and ugly enough to deal with that.

2. For investors: yes this metric is impossible to get from the 10K. There isn’t much I can do about that. If I had my way, MFCF would be a GAAP measure … but I don’t. Regardless, I hope the thought process is useful for you.

Each footnote references a key adjustment, and is the essence of the MFCF definition.

Now we are going to nerd out on each of those footnotes:

a) Stock Based Compensation (SBC)

SBC is a minefield for cashflow analysis. If staff are paid in company stock, then there is no direct impact to cashflow (there is no cash flow).

But, there is an impact to shareholders. As there will be dilution as that stock vests.

The correct way for investors to deal with this, is by using a Free Cashflow Per Share metric. Then accounting for the dilution in the share count for stock issued to staff.

This doesn’t work as an internal measure though. Nothing internal gets measured on a per share basis. You cannot cascade a ‘per share’ metric through the organization.

So there is no perfect way of doing this, but this is how I do it.

Estimate a cost for the period for SBC (total expected cost at issuance spread over vesting period). And then treat that estimate as if it were a ‘cash expense’. With an offsetting cashflow treated as a new equity issuance.

This is not technically perfect.

But it does mean you can attach that SBC cost to individual department budgets. This is crucial because it stops SBC getting treated as a ‘free lunch’ for headcount greedy and frivolous line managers.

And remember our goal here is to drive behavior towards better cashflow generation. Not technical perfection.

b) Capital Expenditure

Capex should get classified into one of two buckets:

Maintenance Capex = recurring capital expenditures required to maintain the current level of operating, and market position. Included in MFCF

Growth Capex = capital expenditure to increase its operating cashflow, or grow the business. Excluded from MFCF

The word ‘maintenance’ tends to trigger accounting purists here. I know, because many of you have contacted me to tell me over the last 12 months.

So listen, I will only explain this once.

Let’s use a coffee shop example again.

• We have 10,000 coffee shops, each with 2 machines. 20,000 machines in total (quick math 😎).

• Those coffee machines get replaced on a 5 cycle. I.e. we need to replace 4,000 machines per year.

• We are opening 1,000 new shops per year. We need to buy 2,000 machines to fit new stores per year.

We are buying 6,000 coffee machines per year, 4,000 replacements, and 2,000 for new stores.

The 4,000 replacements are a Maintenance capex. That spend is needed to maintain the existing asset base. And current operating cashflow.

The 2,000 machines needed for new stores, are a Growth Capex. Expanding the asset base, and future cash generating capacity of the business.

Any spend to repair or maintain existing equipment, is NOT capex at all. That’s an expense in the income statement.

I hope that’s clear. Please stop writing to me about it.

The decision to build new stores should be evaluated alongside paying a dividend. Or paying down debt. Or buying back shares. Etc

That is not the case with the decision to replace end of life assets. If you don't replace those assets; you don't maintain your operating cashflow.

Categorizing capex as maintenance or growth is easy from inside the business:

• Define Maintenance Capex and Growth Capex inside your Corporate Finance Manual.

• Do so in a way that is hyper specific for your business (like the coffee machine example)

• Then build the classification into the capex approval process.

That’s it. By capturing it at source, you will build the language into the business, and they will soon start thinking about maintenance capex and growth capex differently. With different return hurdles. Different evaluation lens.

c) Research & Development

There is a lot to unpack here, but the principles are similar to capital expenditure.

Let’s use Apple as an example:

• R&D costs for iPhone 15 - Include in MFCF. Include in MFCF. Cost of generating cashflow to maintain sales of existing product line.

• R&D costs for Vision Pro - Exclude from MFCF. Capital allocation to new market / growth.

As a default R&D is most likely to be a capital allocation and thus excluded from MFCF. By definition it is developing new things.

Having separate budgets for ‘maintenance R&D’ vs ‘growth R&D’ is key here.

d) Marketing

This is a more subjective area.

How do you separate marketing that is supporting current operations vs driving future growth?

Here is one rule of thumb you could use:

Any marketing that has a payback that extends beyond the period in question gets treated as a non-MFCF capital allocation.

The more a marketing cost is direct response / quick payback, the more likely it is to be part of MFCF. Why? Because the benefit of that investment will get felt in EBITDA in the same period. And so the associated marketing expense should get allocated to it.

If the payback is driven in future periods, then it is likely a capital allocation.

And the more capital you allocate today, the stronger you expect your MFCF to be in the future.

Again, having separate budgets for the two types of marketing expense here is key.

e) Interest and Tax Cashflows

Both interest and tax cashflows are associated with the current net asset base. And should get treated as expenses against MFCF.

The interest expenses are in services of the assets that generated the EBITDA.

There is some nuance here around the treatment of interest on new debt during the year. But this post is already super technical.

Right, we are through the technical stuff.

Still with me?

Don’t take the above points as gospel. Remember, this is a non-GAAP internal measure. You don’t need to benchmark with other businesses. And you don’t even have to agree with me (as long as you don’t mind being wrong).

But, MFCF it’s a behavior driving tool. So define it how you see fit.

Be led by the principles of MFCF rather than ‘rules’, and define it clearly for your business. Set your own rules. A Biotech will need detailed rules on R&D treatment. Whereas a manufacturing business will need that precision on a maintenance capex definition. Likewise a B2B SaaS start up might need more focus on SBC treatment.

So you have defined MFCF for your business.

You have stripped ‘internal capital allocations’ from your cash generating engine.

Turns out you are making more capital allocation decisions than you thought, right? Now you can make them intentionally.

You can evaluate internal capital allocations as opportunity costs against external capital allocation decisions.

You can decide whether building a new factory is better for shareholders than a share buyback. Or you can decide whether you should pay down debt or invest another $20m into brand marketing. We will cover how to do this in a future series on capital allocation.

But we will leave that capital allocation thought behind for now.

The next few posts will be on how you drive MFCF through your business. How you engage and incentivize your whole business around delivering MFCF.

One coffee cup at a time (referring to the Starbucks example in last week’s post)

I’d like to finish this lecture (and yes it is a lecture) with some homework. You didn’t think I was doing all the work, did you?

It will be useful as we move into next week.

MFCF Homework

1. What items in your Income Statement might meet the criteria to be adjusted out of MFCF. Examples:

   • Research & Development

   • Stock Based Compensation

   • Discretionary Marketing

   • Investments / expenses with multi year payback

2. How would you define Maintenance Capex in your business?

3. Write a MFCF ‘chart of accounts’ for your business using the example above as a guide

4. Write a one page ‘MFCF’ guidebook for your business.

Now we have defined ‘cash generation’, next week we will focus on how to measure it. And how to get the right reporting cadence around MFCF. That is the key to driving it harder.

THIS WEEK ON SOCIAL MEDIA

Brace yourself … looks like we accountants are about to be cool again

Only way to make it sound less cool is if they called it: The Bookkeeper.

And h/t to Andrew Lynch for drawing this to my attention:

Check out Andrew’s awesome blog Net Income if you haven’t already.

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AND FINALLY…

That’s all for this week. It’s good to be back

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Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need]