Before you can worry about allocating cash you need cash to allocate. And as we discussed in our first lesson, there are five sources of cash. Let's drill into operating sources a little bit more in this lesson and learn more about what the best practices are that you should be considering an advisor during your CEO. internally generated cash flow is the best kind of cash flow to generate, as is generally an indication of a healthy business model. It's even better when this internally generated cash flow is recurring. As we identified in the course introduction, think of capital allocation separately from operating the business.

Charlie Munger, Warren Buffett's longtime partner of Berkshire Hathaway is quoted with Berkshire Hathaway companies are an odd blend of decentralized operations and highly centralized capital allocation. And what this means is that Mr. Munger and Mr. Buffett spend virtually no time managing the operations Other companies in which birth share Hathaway has invested, but instead focus all of their energies on managing the redeployment of that cash that is generated from these businesses. As Warren Buffett says higher well manage little. So to enable the head office to perform capital allocation, all the internally generated cash flow gets aggregated centrally. This approach prevents the individual business unit managers from holding the cash or making deployment decisions on their own. Why?

Well, it's because these managers don't have a holistic view of the big picture. Allowing them to reinvest in their business may not be the optimal return for the dollar of operating cash flow they generate. Thus, Mr. Buffett takes this decision as to what to do with the free cash flow out of the managers hands. The second source of capital related to operations is the management of working capital. When the focus of management is on earnings. A lot of sins can be hidden in working capital.

Excess inventories can be built up, there can be a loosening of credit terms and collection, accounts payable may not be managed as a strategic source of financing. When any of these things happen, cash gets locked up in the business and is on available for redeployment. For this reason, those CEOs that manage capital allocation aggressively will tend to favor metrics that emphasize cashflow over earnings to force their managers to not only run the business to generate profit, but to maximize the free cash flow. You can't spend earnings However, you can spend cash flow, very shrewd operators will find ways to minimize the investment in working capital by carrying less inventory. Using such techniques as just in time, they will reduce receivables by closely managing the credit policies are finding ways to get cash from their customers up front or they will recognize the value You have negotiating free supplier credit and try to extend paying suppliers for as long as they can without hurting the supplier relationship or impacting the price of materials.

No one metric tells you the whole story. But knowing how to interpret a broad set of metrics helps round out your understanding of the cash generating potential of a business even has evolved into one of the most versatile metrics that is most commonly used by the investment banks. Even it can be used to value an enterprise using a rule of thumb. Even it can also be used to determine how much debt a bank will extend to a business. Even emerging even a divided by sales is often a useful metric for comparing the operating profitability of different competing businesses. The downside of EBITDA is that it ignores the investment in working capital and capital assets, which may vary considerably between different businesses.

Operating cash flow is another helpful metric Particularly for the operating businesses which are designed to generate cash flow. However, operating cash flow is less helpful for those businesses that generate non cash returns through holding investments, over the degree of capital expenditures may vary significantly. free cash flow or distributable cash flows perhaps the most conceptually superior calculation of cash generating ability. You can calculate free cash flow before financing costs, that is what is available to the suppliers of capital of the business or after financing cost. That is what is left over for distribution to the shareholder to calculate distributable free cash flow, you take operating cash flow, less sustaining capital expenditures less scheduled debt repayments. This gives you an indication of how much cash you have available for such things as growth capital expenditures, acquisitions, further debt repayments, dividends or repurchasing.

Have stock. This really gets at the heart of determining how much cash is available for capital allocation decisions. So there are three important things I want you to remember in this lesson. First, operating cash flow gets aggregated centrally and considered separately from operations for capital allocation. Second, don't forget working capital. Working Capital typically requires an investment of cash.

Unless you're lucky enough to have a business model where your customers pay you first, managing all the components of working capital can free up cash for redeployment. Then third, cash flow metrics are better aligned for capital allocation decisions with free cash flow being conceptually the most useful. In the next lesson, we're going to look at deploying capital by investing in our own business for others. Until then,