Understanding free cash flow

26 Oct 2011 by Jim Fickett.

Free cash flow, an alternate measure of company profits often favored by value investors, is usually derived from net income by a number of adjustments. These adjustments make sense if you understand that what is going on is simply a switch from the timing conventions of accrual accounting to the timing conventions of cash accounting.

Someone new to investing might think it would be straightforward to know how much money a company is making. Those of us who have spent time reading annual reports know otherwise. The main ideas are simple, but the details are often complex.

Conceptually, if you take revenues and subtract expenses you get either net income, under accrual accounting, or free cash flow, under cash accounting. Either one of these measures can be (sometimes deliberately) distorted by unusual events or accounting decisions, but it is hard for both of them to be far from the truth at the same time. And because the news concentrates on net income, that measure is perhaps fudged more often than free cash flow.

So an investor should be interested in free cash flow and value investors do, indeed, often emphasize this measure. (For an introduction, see Investopedia).

Either net income or free cash flow can be computed directly from the individual transactions in a company's books, but that is not what occurs in practice. Under US Generally Accepted Accounting Principles (GAAP), which govern, in particular, SEC corporate filings, income is the basic measure, and cash flow is derived from it. Under GAAP, the cash flow statement, which tracks the change in the overall cash position of the company, is divided into cash flow from operations, cash flow from financing activities, and cash flow from investing activities. Cash flow from operations is the closest to the idea of income, and (free cash flow) = (cash flow from operations) - (capital expenditures).

You can find any number of explanations of free cash flow on the web, most of which provide various formulas. I always found these formulas, and the GAAP derivation of cash flow from operations, a bit opaque. I used the formulas, but without a good gut feeling of what was going on. Does that matter? Yes. Accounting formulas used by investors, including some for free cash flow, are often simplifications, working in most cases but ignoring certain complexities. If you understand why the formula is what it is, you are more likely to notice when a simplification is inappropriate, or to catch an unusual accounting item that needs explanation.

The difference between accrual accounting and cash accounting is one of timing. Under cash accounting, revenues and expenses are accounted for when the payment is actually made; under accrual accounting, revenues and expenses are accounted for when earned. So if a company makes a sale in May but doesn't get paid until July, the revenue is recognized for net income in May, but for free cash flow in July.

As I was reading a section of Klarman's Margin of Safety, in which he explains why EBITDA (earnings before interest, tax, depreciation and amortization) is a nearly useless measure, the (admittedly simple) fact dawned on me that the way to understand the formulas for free cash flow is this: all that is going on is switching from the timing method of accrual accounting to the timing method of cash accounting.

Consider, for example, what happens when a company makes a sale that will be paid for 90 days hence. This increases accounts receivable by the amount of the sale, and that increase goes into net income. In the adjustments to derive cash flow from net income, one primary adjustment is to subtract any change in net working capital from net income. Net working capital is current assets, including accounts receivable, minus current liabilities. Thus the contribution of the sale to net income is subtracted back out, as is appropriate, since the cash has not yet been received. Three months later the payment is made, accounts receivable goes down, and the subtraction of working capital adds back in the revenue to free cash flow.

To take one further example, capital expenses are handled in accrual accounting by spreading the cost over the useful life of the investment, as depreciation charges. So to get from net income to free cash flow, one should add back in depreciation charges and subtract out capital expenditures. The depreciation charges are already added back into cash flow from operations, but the balancing charge for capital expenditures is not taken out. Hence the need to subtract capital expenditures from cash flow from operations, in order to arrive at free cash flows.