In earlier article, we learn the importance of Cash compared to merely Accounting Earnings/Profit.
This article illustrates the computation of free cash flow concept which is the conversion of the net income(accounting earnings/profits) into cash less capex.
Using the formula for Free Cash Flow which is=[ Net Income+Non Cash items-Changes in net working capital (NWC)- Capex + Financial charges ]
Some who are not familiar with the above will start asking the rationale for using such adjustments. The below table articulated the rationale for such adjustments to net income to come to free cash flow.
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Rationale for Doing So |
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NET INCOME |
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Plus: Depreciation, goodwill amortization, deferred income taxes, bond discount amortization, foreign exchange adjustments, earnings of non-consolidated firms and any other non-cash items |
No cash involved; they hide the true cash generated by the firm. |
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Minus: Changes In Net Working Capital (NWC) like additional receivables and inventory net of payables and accruals |
Increased credit sales and premature revenue recognition shows up in increased receivables, inventory accounting differences show up either in the income statement or inventory plus producing for inventory costs just as much as producing for goods sold for cash, payables are sometimes manipulated |
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Minus: Capex but not “diversifying” investments unrelated to existing operations |
Adding depreciation(wearning down of capital) without subtracting capex overstates cash generated. |
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Plus: Financial charges (add back after tax interest charges using the marginal tax rate)
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Two otherwise identical firms will have different free cash flow if they have been financed differently |
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