Your Financial CEO: Managing Free Cash Flow for a Wealthier Tomorrow
Evan Louise Madri?an
Finance & Investment Writer and Author | Value Investor | Registered Nurse ?My book and website are my way of empowering Millennials and Gen Zs to take control of their financial lives.?
by elmads
Introduction
Our personal financial free cash flow is the amount of money that can be used for saving, investing, and leisure purposes.
The narrative changes if a person allocates his or her free cash flow to generate more money in the future, because that compounds the reinvested capital massively and, in turn, increases a person’s intrinsic value.
In my previous blog “Value Your Finances Like Valuing Assets: Putting Valuation in a Personal Financial Context", we used Marcus as a hypothetical person to show the three case scenarios (worst, base, and best). I explained how we can make our own free cash flow projections based on our current income-generating capabilities, our priorities, plans, financial knowledge, skills, habits, and discipline.
In our Marcus example, we assumed that he would use his free cash flows, less debt, for saving purposes, while the rest would be spent on his family’s wants and leisure activities.
What happens if Marcus uses his free cash flow to generate additional income? Instead of using it for just stashing away money in a bank savings account, he uses a portion of his free cash flow, less debt, to make more of it.
From a business point of view, it’s using the company’s free cash flow to grow the business for the sole purpose of increasing its profitability. Either they invest it to purchase additional property, land, and equipment, hire more people, boost their marketing spending, for research and development, acquire another company, merge with another company, and others.
What I’m painting here for you is this: to look at your personal finances from a business perspective. Handling the cash flows is like having your own business.
You are the Chairman of the Board, the Chief Executive Officer, the Chief Operating Officer, and the Chief Financing Officer of your life. You have the control to make the best decision possible so that you can achieve the financial life you want for yourself and your family.
Therefore, for every free cash flow less debt you make for yourself and your family, you strategically use a portion of it to expand your financial fortress.
You are the Financial CEO of Your Financial Life: Manage your Free Cash Flow for a Wealthier Tomorrow
Costco Wholesale Corporation
Costco Wholesale is a big-box retailer and wholesale warehouse club. As the company states on their website.
“Costco is a membership warehouse club dedicated to bringing our members the best possible prices on quality brand-name merchandise. With hundreds of locations worldwide, Costco provides a wide selection of merchandise, plus the convenience of specialty departments and exclusive member services, all designed to make your shopping experience a pleasurable one.”
They are one of the best-operating big-box retailers worldwide. Their main source of revenue is membership. For every 1 million members worldwide, Costco generates at least $60 million in revenue from membership fees alone. As of early 2022, Costco had over 114 million cardholders. This demonstrates how vital membership fees are to the company's bottom line.
Their membership grants different deals depending on the membership tier.
Currently the company has 859 stores globally.
This is not specifically about Costco, but an overview of how we can use the concept of business analysis to improve our financial lives.
Costco’s Revenue and Net Income
From 2002 to 2023, Costco has been generating increasing revenue and net income.
In 2002, their revenue was $38.7 billion, while their net income was $699 million, with a 1.81% net income margin.
NOTE: To get the net income margin, divide the net income of the company by its revenue within the same period.
Today, in 20203, their revenue stands at $242 billion with a net income of $6 billion. Their net income margin is 2.60%.
NOTE: You might argue that their net income margin is miniscule, which is true, but you have to understand that big-box retailers always have low margins. It’s just the nature of the industry and the businesses in it.
Despite the low income margin of the company, their revenue still had a 6-fold increase, and then their net income shot up by 900% while their net income margin nearly doubled over the span of 21 years. That’s a feat of an efficiently managed business and a top-tier company.
The question here is: How did Costco do it? I know this is a broad question because this will require us to go back and review each year’s strategy taken by the management since 2002. This is an arduous task because it will require a lot of reading.
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Nevertheless, we can still do this from a wider perspective without the need to delve deeper into Costco’s rabbit hole. This can be done by reviewing their financial reports.
In the past, this would also require me to get each year’s financial report, but since I’ve subscribed to Tikr.com, I've been able to shed off a substantial amount of time by getting financial data directly from the companies I analyse. The image above of Costco’s revenue, net income, and net income margin was taken from Tikr.com.
Costco Expansion and Cash Generation
“The company's first location, opened in 1976 under the Price Club name, was in a converted airplane hangar on Morena Boulevard in San Diego. Originally serving only small businesses, the company found it could achieve far greater buying clout by also serving a selected audience of non-business members. With that change, the growth of the warehouse club industry was off and running.
Costco has always stayed true to keeping its prices low, and they do this by making sure that they don’t put a large premium on their sold products (usually only less than 12%), while their competitors are selling at more than a 20% price premium on goods sold. This is made possible because Costco sells items in bulk. The company makes a conscious choice to prioritise customer satisfaction over short-term profits. This business model and their strategy proved successful, as a lot of buyers from all walks of life go to Costco and purchase their membership cards.
Below is an oversimplified bird's-eye view of Costco Wholesale throughout the years.
A great business model that prioritises customers (sells items at low prices compared to competitors and sells them in bulk) > increases customer demand > increases supply by opening a new store
This is mostly supply- and demand-driven, but as I’ve written above, this is only an oversimplification of what happened to Costco over the years because there are nuances to what makes it a great business. The warehouse experience, product placement, their suppliers, the remaining 20% of revenue drivers that are not membership-driven, their return policies, their employee retention rate, their customer loyalty, their service to customers, the management, their continued focus on upholding the company’s philosophy since day one, and a lot more
Let’s go back to its financials, shall we?
The company has continued to thrive these past few years. They’ve been able to expand by opening new stores.
From 2005 to 2023, their stores/warehouses doubled from 433 to 859. One of their drivers of growth is the store opening. They were able to capture new customers while retaining loyal ones in different parts of the world. See Image below taken from https://en.wikipedia.org/wiki/Costco
And to open those new stores, they require capital. Guess where they got the capital? It’s either through their free cash flow and cash on hand, acquiring debt, selling more shares of their business via the stock market, or a mix of the three. See image below.
I’ve discussed this in detail in my blog titled “??The Capital Markets: Exploring the Dynamic Relationship between Public Companies and Investors”.
It is estimated that Costco spends approximately $100–$400 on every store they open. That store becomes a property, plant, and equipment asset, which will generate them additional revenue in the future, provided it is well managed. Not all stores will do well; some will do poorly, while others will do well.
They did these for decades, and it showed in their income statement. Via the relationship between the growth of their equity and net income.?
As shown above, every time Costco invests a portion of their cash flows for opening a store or other business endeavour that is related to growing the business, the equity side of the company (where assets minus liabilities) also increases. If their investments were done thoroughly, both from a financial and business operations point of view, then the returns from the initial investment would have been the beautiful fruit of their labour. That’s what happened with Costco Wholesale Corporation.
NOTE: The story differs if the growth of net income is generated more by debt, meaning the cash used to open the stores in the past was raised through debt. If the liability side is higher than the asset side of the company, then its equity will be in the negative.
All of what I’ve explained here can be summarised in two financial metrics, return-on-equity (ROE) and return-on-invested capital (ROIC), which I’ve explained in detail in my blogs that I’ll link below.
A low ROIC and ROE could indicate, but not exclusively, poor financial investment and/or poor run operations.
Knowledge is my Sword and Patience is my Shield,
elmads
DISCLAIMER:
This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.