Goodbye Cheap Cost of Capital, Hello Free Cash Flow

Sometimes, I get sucked into some rabbit hole of inquiry. Lately, it has been debt. I studied various interest rate charts over the last 50 years. I analyzed treasuries, mortgages, yield spreads, SBA loans, and debt financing across credit profiles. I reached a consistent conclusion: debt was cheap over the last five years. I know, mind-blowing. Not since the 50s has the US (and many developed nations) had such inexpensive debt. I then asked myself why so many newbie companies chased equity financing when the debt was so affordable?

Because equity financing was often cheaper, companies had excellent options for raising money — a perfect storm. I reviewed valuations and P/E ratios for decades. Over the last five years, valuations exploded, and the funding supply was abundant. SPACs, innovative convertible debt instruments, and the crypto explosion added more paths to financing. This frothiness reminded me of another time valuations spiked to the levels we saw in 2021 — the late 1999/2000 crash. Again, competition and rich funding supply led to high valuations and allowed venture-backed entities to bring in more capital with less dilution, thus inexpensive equity financing.

Which led me to my final question, when in history has equity and debt financing (overall cost of capital) been historically inexpensive at the same time? I couldn’t find it. I surmise the cost of money over the last five years through 2021 across most risk categories was the historical bottom. To confirm my thinking, I reviewed WACC time series charts by sector from Seeking Alpha that supports my thesis (see chart below). I’m not going to delve into why this is the case or deep dive into WACC, but I postulate the cheap capital ship has sailed, and companies must adjust — especially newer companies.

If you are a company less than ten years old, you have not experienced expensive debt and equity financing. Congrats, I hope you took advantage of this historical anomaly and have a nice cash cushion. When the cost of capital is that low and seemingly unlimited, organizations can rightly focus on revenue growth and are awarded accordingly with titles like unicorns. However, with financing costs rapidly increasing in 2022, companies must pivot and prioritize free cash flow (FCF) and FCF growth or risk running out of funds.

FCF adds back non-cash expense lines such as depreciation and amortization. It also adjusts for capital, working capital, and actual cash inputs/outputs. As a result, companies prioritizing positive free cash flow will likely survive a prolonged recession, stagflation, and stricter financing conditions. Conversely, negative free cash flow companies will face massive dilution at the next capital raise or failure once current cash positions evaporate.

To reach positive FCF, executive teams need to focus on the entirety of P&L, balance sheet, and cash flow statement. Here are a few ideas for improving FCF.

• Accounts payable and receivable terms — work with vendors and customers to renegotiate terms. Extend terms with vendors and reduce with customers even if this means offering a discount or paying more. With high inflation, it is essential to minimize net working capital needs. Working capital equates to current liabilities minus current assets. If the balance is out of whack, generous customer terms can eat cash.
• Create a money map of all cash expenditures over the last 12 months. Rank according to the total expense and categorize whether the outlay was critical or non-critical to operating the business. Then pause or stop non-critical costs and contracts. Negotiate with the most prominent vendors; even small reductions or improvements add up.
• Reduce or delay capital expenditures except for necessary investments that reduce operating costs in the next 12 months. Prioritize short-term break-even investments.
• A shift from fixed cost operating strategies to variable costs wherever possible will allow the organization to better flex based on the performance of the business. It may seem counter-intuitive, but contractors can fill resource gaps as a variable cost.
• Look for areas to automate using RPA, but negotiate performance-based payment models. For example, if the RPA team saves the company $100K, it is paid a percentage of the saving versus the upfront service cost.
• There is a cost to everything you are doing, do less. For example, if you have eight strategic initiatives, reduce them to four. Eliminate waste in the organization.
• Anything lavish, company events, conventions, travel, leases, furniture, and dinners must be reduced or eliminated.
• Cost reduction directives, employee right-sizing, and price improvements are pragmatic levers to generate more cash.
• Secure a revolving line of credit, even if expensive that can act as insurance during challenging periods. In addition, access to cash can help with working capital.

Having watched the aftermath of the 2000 crash, the companies that survived and even prospered attacked the worst-case scenario with a strong plan — wide-eyed to downside risk. On the other hand, I sense that in today’s economic climate, many organizations have a posture that this will pass. And it surely will, but does your company have the cash reserves to wait it out? Shifting focus to FCF may be the difference.

Other ideas on how to increase FCF?