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MagicDiligence (< 20)

How to Calculate Free Cash Flow Correctly

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November 19, 2013 – Comments (1) | RELATED TICKERS: BKE

Free cash flow - the amount of cash generated by a company not needed to maintain operations - is quite possibly the single most important statistic in business. The purpose of any business is to generate cash for its owners (otherwise, why be in business?). This cash can then be put to work providing value to shareholders in multiple ways: by paying a dividend, buying back shares, or re-investing in the business to grow revenues and profits. No company can survive and thrive over the long term without generating and increasing the amount of cash it generates.

Given this, it is important for investors to know how to calculate free cash flow correctly.

Standard Free Cash Flow Calculation

The textbook calculation is as follows:

Free Cash Flow (FCF) = Net Cash from Operations - Capital Expenditures

All public companies are required to include a cash flow statement as part of their SEC filings. In this statement is listed the Net Cash from Operations, which is the actual amount of cash brought in or used by the company's operations for the reporting period. Capital Expenditures (also in the statement) are subtracted, as these ostensibly represent the cost of maintaining or replacing the assets the business relies on to generate profits. The leftover amount is free cash flow.

Growth vs. Maintenance Capital Expenditures

The problem with the standard calculation is that it assumes all capital expenditures are for maintenance purposes. But this is not the case. Consider current Magic Formula® stockBuckle (BKE), a mall clothing retailer. Capital expenditures for this company include the cost of opening and furnishing new stores, in addition to maintaining existing stores. With the standard calculation, we are penalizing Buckle's growth investments and understating the actual free cash thrown off by the business.

What we need to do is subtract only maintenance capital expenditures from net cash from operations. The problem is, very few companies actually break out growth from maintenance capital expenditures.

Fortunately, we have an approximation that is always available: Depreciation (often grouped with amortization). Depreciation is the value that past capital expenditures have lost during the reporting period. At the end of an asset's life, its full value will have been depreciated and the company will need to pay to replace it. Voila, an excellent estimation of maintenance costs! Consider Buckle's past 5 years:

01/2009: CapEx $47m, D&A $22m, 21 new stores, 387 total stores
01/2010: CapEx $51m, D&A $25m, 20 new stores, 401 total stores
01/2011: CapEX $55m, D&A $30m, 21 new stores, 420 total stores
01/2012: CapEx $37m, D&A $33m, 13 new stores, 431 total stores
01/2013: CapEx $30m, D&A $34m, 10 new stores, 440 total stores

As new store openings declined, capital expenditures fell. But depreciation and amortization is linked to the total number of stores. This makes sense - more stores, more maintenance costs.

Modified Free Cash Flow Calculation

One way to incorporate the above into a new calculation is to simply substitute depreciation for capital expenditures, like this:

Free Cash Flow (FCF) = Net Cash from Operations - Depreciation and Amortization

The problem here is, as we see above, capital expenditures can sometimes come in below D&A, due to things like intangible asset and goodwill write-downs. In this case, we should just revert to the standard calculation. Putting it all together, we get:

Free Cash Flow (FCF) = Net Cash from Operations - MIN(Capital Expenditures; Depreciation and Amortization)

Using the above formula, we would use depreciation and amortization to calculate Buckle's 2012 maintenance costs ($37m > $34m), but use capital expenditures to calculate 2013 ($30m < $34m).

This is how to calculate free cash flow correctly. It gives us the best of both worlds and the best approximation of a company's cash generating capacity.

 

1 Comments – Post Your Own

#1) On November 19, 2013 at 1:55 PM, Mega (99.98) wrote:

Good post. Adjusted FCF is somewhat comparable to Owner Earnings.

http://en.wikipedia.org/wiki/Owner_earnings

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