The Daily Technical #115: Why are increases in accounts receivable a cash reduction on the cash flow statement?

Good morning. Welcome to the 115th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Define free cash flow yield and compare it to dividend yield and P/E ratios.

Free cash flow yield ("FCFY"): Free Cash Flow (FCF) per Share / Current Share Price (For this calculation, FCF will be defined as cash from operations less capex).

Similar to the dividend yield, FCF yield can gauge equity returns relative to a company’s share price.

Unlike dividend yield, however, FCF yield is based on cash generated instead of cash actually distributed.

FCF yield is more useful as a fundamental value measure because many companies don't issue dividends (or an arbitrary fraction of their FCFs).

If you invert the FCF yield, you'll get share price/FCF per share, which produces a cash flow version of the P/E ratio.

This has the advantage of benchmarking prices against actual cash flows as opposed to accrual profits.

However, it has the disadvantage that cash flows can be volatile, and period-specific swings in working capital and deferred revenue can have a material impact on the multiple.

Common Mistakes

1. Mistaking free cash flow yield (FCFY) for dividend yield because both relate to share pricing. Remember, dividend yield refers to cash distributed to shareholders, while FCFY focuses on cash generated. Differentiate clearly by emphasizing the source of cash in each metric.

2. Forgetting to subtract capital expenditures when calculating free cash flow, inaccurately inflating FCF. Always remember to deduct capex from operating cash flow to compute the genuine cash available from business operations correctly.

3. Ignoring the implications of volatile cash flows on FCFY’s reliability. Account for the fact that temporary changes in working capital and deferred revenue can skew cash flow figures, thus impacting FCF yield assessments.

4. Misinterpreting FCFY’s relation to the P/E ratio, focusing solely on benefits without acknowledging cash flow volatility issues. Recognize both as benchmarks but emphasize FCFY benchmarks against actual cash flows, unlike the more stable, accrual-based earnings in P/E.

TL;DR

• FCFY Formula: FCF per share / current share price;

  FCF = cash from operations - capex.

• FCFY vs. Dividend Yield: Measures cash generated, not distributed; valuable for non-dividend firms.

• Cash Flow vs. P/E Ratio: Inverted FCFY = share price / FCF per share; evaluates with cash flows, not accruals.

• Advantages of FCFY: Benchmarks against actual cash, offering a fundamental company value.

• FCFY Limitations: Volatile due to working capital swings affecting cash flow consistency.

TODAY’S QUESTION
Why are increases in accounts receivable a cash reduction on the cash flow statement?

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