Microsoft's A-Grade Is Built on Real Cash

The Grade

Microsoft earns an A from Aureus. Not because of Azure growth narratives or AI hype. Because the company converted $71.6 billion of its $281.7 billion in revenue into free cash flow over the trailing twelve months. That's a 25.4% FCF margin.

In technology, the A-grade threshold sits at 25%. Microsoft clears it. Barely. The base grade starts at A, then Aureus applies modifiers for balance sheet health and trend stability. Microsoft gets a +0.5 bump for maintaining that margin while carrying manageable debt, and another +1 for a debt-to-FCF ratio of just 0.8x. Final grade: A.

The grade system isn't subjective. It's mechanical. FCF margin determines the base. Balance sheet quality and consistency move it up or down. Microsoft's numbers justify the grade without room for interpretation.

What Makes the Margin Work

A 25.4% FCF margin means Microsoft keeps a quarter of every revenue dollar as actual cash after covering operating expenses and capital expenditures. For context, that's $71.6 billion in a single year. Most S&P 500 companies would celebrate a 10% margin.

The cash conversion rate tells the rest of the story: 133.7%. Microsoft's operating cash flow of $136.2 billion significantly exceeds its net income. That gap exists because of non-cash charges like depreciation and stock-based compensation. The company isn't just reporting earnings on paper. It's collecting cash that exceeds what GAAP accounting shows as profit.

This matters because free cash flow is what's left after Microsoft pays for the servers, data centers, and infrastructure required to keep Azure and Office 365 running. Capital expenditures are real. FCF accounts for them. Earnings don't always.

The Balance Sheet Reality

Microsoft carries $60.6 billion in total debt against $30.2 billion in cash. That's a net debt position of $30.3 billion. Some investors see that number and assume it's a problem. It isn't.

Debt only matters relative to cash generation. Microsoft's debt-to-FCF ratio is 0.8x. The company could pay off every dollar of debt in less than a year using free cash flow alone. That's not leverage risk. That's optionality.

The current ratio sits at 1.35, meaning Microsoft has $1.35 in current assets for every dollar of current liabilities. Comfortable, not excessive. The debt-to-equity ratio of 0.18 confirms the company isn't reaching for growth through borrowed capital. It's funding operations and expansion with cash it actually generates.

Aureus upgrades companies with debt-to-FCF ratios below 2x. Microsoft's 0.8x earns that modifier easily.

Quarterly Performance

Free cash flow varies by quarter. Always. What matters is whether the variation reflects seasonality or deterioration. For Microsoft, it's seasonality.

The five most recent quarters:

• Q1 2025: $6.5B FCF on $69.6B revenue
• Q2 2025: $20.3B FCF on $70.1B revenue
• Q3 2025: $25.6B FCF on $76.4B revenue
• Q4 2025: $25.7B FCF on $77.7B revenue
• Q1 2026: $5.9B FCF on $81.3B revenue

The pattern repeats. First quarters consistently show lower FCF because of how enterprise licensing renewals and capital spending align with Microsoft's fiscal calendar. But all five quarters were positive. No single quarter dipped into negative territory.

YoY FCF growth sits at -9.3%, comparing Q1 2026 to Q1 2025. That looks like a decline until you remember both quarters represent the seasonal low point. The decrease is minimal and likely reflects timing of capital expenditures related to AI infrastructure buildout.

FCF consistency measures at 0.53. Lower numbers indicate more stability. Microsoft's quarterly variance is real but predictable. The company isn't lurching between profit and loss. It's cycling through a known pattern.

What the Market Misses

Investors fixate on Azure growth rates and AI product announcements. Those matter for future revenue. But current valuation should reflect current cash generation. Microsoft is already converting a quarter of its revenue into free cash flow today. Not projected. Not modeled. Actual.

The net debt position occasionally triggers concern. It shouldn't. Net debt exists because Microsoft chose to issue bonds at low rates while holding cash offshore or deploying it into buybacks. The 0.8x debt-to-FCF ratio proves the debt is trivial relative to cash generation capacity.

Another missed detail: the stability. Five consecutive positive quarters with predictable seasonality. No surprises. No quarters where operating cash flow collapsed or capital expenditures spiked unexpectedly. Microsoft's cash flow machine runs consistently.

What to Watch

Capital expenditures will rise. AI infrastructure requires it. The question is whether Microsoft can maintain FCF margin while scaling data center capacity. If capex grows faster than operating cash flow, the margin compresses. So far, it hasn't.

The other watch point is revenue growth sustainability. Microsoft's 25.4% margin depends on revenue continuing to scale. If growth slows significantly, fixed costs eat into margins. The company has pricing power and sticky enterprise contracts, but no moat is permanent.

Debt levels matter less than debt trajectory. If Microsoft starts levering up to fund AI investments, the debt-to-FCF ratio could move above 2x. That would trigger a grade modifier. Current trajectory suggests this isn't happening.

The Bottom Line

Microsoft's A-grade reflects reality, not optimism. The company generates more than $70 billion in annual free cash flow on a 25.4% margin. Debt is minimal relative to that cash generation. Quarterly results show consistency and predictable patterns. The balance sheet is clean.

This isn't a story about what Microsoft might do with AI or how fast Azure could grow. It's arithmetic. Revenue in, expenses out, cash left over. Microsoft keeps 25% of what comes in. That's an A.