The operating income reported in the financial statements is merely for accounting purpose, and has to be converted to free cash flow which is the actual cash available after adjusting for non-cash charges, changes in working capital and capital expenditure as detailed below:
o Depreciation – It represents a decrease in tangible assets value overtime and should be added back to the net income as it’s a non-cash charge.
o Amortization – It is a non-cash charge which represents a decrease in intangible assets value overtime. If the firm amortizes intangibles, that expense should be added back to net income to determine FCFF.
o Deferred Taxes – Changes in deferred tax liabilities would be added back to net income if the firm will be able to consistently defer taxes in the future and any change in deferred tax asset would be subtracted if it will consistently persist in future.
o Stock based Compensation– The share of the total compensation expense which is paid through stock options is again a non-cash charge, and therefore it is added back.
Working Capital Changes
The Working Capital is the measure of cash needs of the company for day to day business activities, it is the short term financing needs of the expanding business operations. It is calculated as current assets (excluding cash) minus current liabilities (excluding debt).
In accruals system, the actual cash that changes hand is different from revenues and expenditures that are reported. Thus the changes in working capital would not affect the Net Income and will only be reported in cash flow statements, therefore working capital adjustments to Net Income is very important to determine free cash flow.
Working Capital changes would affect the cash flow in following ways:
o The increase in currents assets such as accounts receivables or inventory would lead to lower cash flow then Net Income.
o The increase in current liabilities such as account payables would lead to higher cash flow then Net Income.
Capital Expenditure or CapEx, refers to the investment made by the company to acquire or upgrade physical assets such as property, plant and equipment. These expenditures can include anything from repairing old machinery, to purchasing a piece of equipment, or constructing a new factory.
Factors affecting future capex requirements for a company include:
o Future Plan of the Business: Any changes or adjustments to the company’s underlying business model can impact the capital expenditure required in the future.
o Depreciation Method Used: The depreciation policy must be reviewed when assessing capital expenditure requirements for future. Some cases which might require adjustments include circumstances where assets are not depreciated over estimated useful lives, or salvage values have not been considered.
o Nature of Industry: The nature of the industry often dictates the capex requirements for a business. For example, software firms tend to have lower initial capex and higher asset turnover, as compared to oil production firms which have high initial capex and low asset turnover.
o Technological Advancement: Companies in industries with swift advances in technological innovation find it necessary to keep up with competition by continuously retooling.
Free cash flow as a measure of value is cherished a lot by the investment community as it provides a wealth of information on company performance and is a key component of DCF valuation. The true health of a business is reflected in the free cash flow it generates, and its accuracy is in turn dependent upon the quality of the cash flow adjustments. Therefore, it is of utmost importance that the adjustments are done with great precision and minimal bias involved.