Free Cash Flow (Part II)

Yesterday provided an introduction to the basics of using free cash flow in a company analysis. Part II of this discussion focuses on free cash flows limitations.

There are two ways to calculate free cash flow. The first uses the company’s cash flow statement and balance sheet.

Free Cash Flow = Cash Flow From Operations – Capital Expenditures

The second uses the income statement and balance sheet.

Net income
+ Depreciation/Amortization
-Change in Working Capital
-Capital Expenditure
-------------------------------
= Free Cash Flow

Without a regulatory standard for determining free cash flow, investors often disagree on exactly which items should classified as capital expenditures. As a result, it is important to “check under the hood” of companies with high levels of free cash flow and see if they under report capital expenditures and R&D.

Companies can also temporarily boost free cash flow by stretching out their payments, tightening payment collection policies, and depleting inventories. These activities diminish current liabilities and changes to working capital.

A more complicated accounting is the hiding of receivables. This occurs when a company records a revenue in which cash will not be received within a year, but places the receivable in another line item outside of “non-current” assets. Accordingly, revenue is recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost.

Like all performance metrics, free cash flow has its limitations. Still, it is a great place to start searching for quality investments.

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Peter J. Lazaroff