Free cash flow is a very common term used in Corporate Finance whether to assess the viability of capital investment, to value share and to understand the true cash flow position of a company.
This article seeks to give readers a better understanding of the Free cash flow concept by reviewing its formula and the rationale for the adjustments made in computing free cash flow of a company
The formula of Free cash flow is:
Net Income + Non Cash items-changes in net working capital (NWC)- Capital expenditure(Capex) + financial charges
Below are the rationales for such adjustments to net income to get to free cash flow of a company:
NET INCOME
Plus:
Depreciation, goodwill amortization, deferred income taxes, bond discount amortization, foreign exchange adjustments, earnings of non-consolidated firms and any other non-cash items
{Rationale: No cash involved; they hide the true cash generated by the firm.}
Minus:
Changes In Net Working Capital (NWC) like additional receivables and inventory net of payables and accruals
{
Rationale: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}
Minus:
Capex but not “diversifying” investments unrelated to existing operations
{
Rationale: Adding depreciation(wearning down of capital) without subtracting capex overstates cash generated.}
Plus:
Financial charges (add back after tax interest charges using the marginal tax rate)
{
Rationale:Two otherwise identical firms will have different free cash flow if they have been financed differently}
