Cash Flow Analysis Blog #2 – cash flow patterns
“Nobody knows the future with certainty. We can, however, identify ongoing patterns of change.”
As an investor and a business person, it is very important to recognize that there are different stages of maturity with each company one invests in. The risk versus return profiles differ whether one is investing in an early stage, growth stage, or mature company. For an investor, an early stage company typically requires large capital investments and long holding periods to profitability, hence a riskier asset to hold. However, such risk-takings are rewarded with larger returns. On the opposite side, investing in a mature company may not require as large of capital investments or holding period to achieve profitability. This less-risky asset is typically rewarded with smaller returns compared to its early stage company investment counterpart.
So, who should invest in each type of investment? If one has a higher risk tolerance, such as a venture capital investor, early stage companies are the preferred investment vehicles. On the opposite side stand private equity investors who prefer mature company investments. Early stage, growth stage, mature stage, and declining stage can all be observed from a company’s cash flow patterns. With OCF denoting Operating Cash Flow, ICF denoting Investing Cash Flow, and FCF denoting Financing Cash Flow, we can summarize the different cash flow patterns as follow:
* Courtesy of Dr. Bo Ouyang, Penn State University Great Valley (2016)
It is important to note that a negative free cash flow with a company is not a bad sign in itself. Such company might be making large investments that can earn a high return and pay off in the long run. As we see with our example company Caterpillar (CAT), their Operating-Investing-Financing (O-I-F) pattern of + - - cash flows suggest that the company is a mature firm.