Free cash flow – a valid executive incentive performance measure when profit is more important than growth?

At a time when investors have rotated from companies pursuing growth at all costs to those that generate strong cash flows, some boards may consider adopting cash flow as an incentive plan performance measure.

Free cash flow (FCF) is the cash flow available to investors after a company has made necessary investments in fixed assets and working capital. That is, it is the cash left over after the company has paid for operating expenses (i.e., operating cash flow) and capital expenditures.

Forecast FCF is a key metric for all investors, whether they are “growth” or “value” oriented, as unlevered free cash flow (or free cash flow to the firm) is the basis for discounted cash flow models that are used to estimate the enterprise value of a business and levered free cash flow (or free cash flow to shareholders) is the basis for discounted cash flow models that are used to estimate the equity value of a business.

But as a performance measure FCF has drawbacks. To illustrate the issues, assume a company generated FCF of 100 last year as follows:

Net income



+ Non-cash expenses


Depreciation and amortisation

– Increase in net working capital


Net working capital defined as accounts receivable plus inventory and other current assets, less accounts and other payables

Operating cash flow



– Capital expenditures


Investments in fixed assets

Free cash flow




Based on the FCF of 100 assume the board introduces an FCF target for the next year of 110 in the short-term incentive plan. Management can of course achieve this target by increasing profitability and manage incoming and outgoing cash flows more efficiently for the period, which is beneficial for investors. But there are also ways management can try to “game” the FCF target to receive an incentive payout, including:

  • Not paying invoices on time near the end of the financial year so that accounts payable will be higher, and the increase in net working capital less than otherwise expected, to increase operating and free cash flow
  • Not making necessary investments in fixed assets for maintenance or expansion purposes during the year, i.e., deferring capital expenditures, to increase free cash flow

To avoid these unintended consequences the board can instead adopt a “normalised” measure of cash flow. That is, what would free cash flow be assuming management had paid invoices on time and made necessary investments in fixed assets? In addition, the board may consider removing the impact of expansionary capital expenditure for profitable investment purposes. But, while this seems eminently sensible, most proxy advisers and their clients may have difficulty supporting it because transparency (i.e. what can be derived from financial statements) appears to over-ride what is sensible.

Some companies consider earnings before interest, taxes, depreciation and amortisation (EBITDA) as a proxy for cash flow.

While using EBITDA as a measure avoids the issue of management trying to game the target by deferring invoice payments or capital expenditure, EBITDA can also be referred to as “bullshit earnings” in the words of Charlie Munger (See him HERE).

Amortisation of acquired intangible assets is generally fine to exclude for valuation purposes as the accounting standard effectively double-counts the expense when assets are replaced (see example HERE). The problem with EBITDA is that it excludes depreciation. While depreciation of fixed assets is a non-cash charge, it is certainly a real expense for investors in the business as depreciated assets have to be replaced for the company to keep generating income. In a normal year the company would be expected to spend at least the depreciation charge in new capital expenditure to maintain existing assets. That is, depreciation is a form of “normalised” capital expenditure for the business.

As depreciation is an estimate of expected annual cash outflow in the form of future capital expenditure, it should be added back to EBITDA to arrive at a normalised measure of cash flow to the firm. The proxy for cash flow that is better suited as a performance measure is EBITA – earnings before interest, taxes and amortisation. (Even then, for high technology companies some proxy advisers and investors also object to ignoring employee share based payments expenses. While non-cash, it is a very real dilutionary expense in these companies for these stakeholders.)

Given the near future uncertain economic growth and high inflationary environment, a revisit of performance conditions, including a possible cash flow metric, would be worthwhile for many companies.

© Guerdon Associates 2024
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