Many companies and analysts take only the first of these three components,
Cash Flow from operations and (rather slyly) call it simply "Cash Flow" and
imply that it is a performance indicator. This definition omits the Cash Flow
from financing which seems quite appropriate since borrowing or repaying loans
is not in any way an indicator of profitability. But this (Operating) Cash Flow
also omits the required capital spending that is necessary to replace worn out
assets. For that reason it is very flawed as a measure of profitability. This
definition of Cash Flow should not be used as any kind of substitute for net
To add to the confusion about Cash Flow another large group of companies and
analysts use the term Cash Flow to mean simply net income plus depreciation and
deferred income taxes. (See the "box" for an explanation of why those two items
are added back to net income.) This is actually only a sub-component of Cash
Flow from Operations. Technically speaking, it is Cash Flow from Operations
before the "increase in non-cash working capital". This accounting jargon means
the Operating Cash Flow before the net increase in money tied up in accounts
receivable and inventories less the cash effectively provided by customers
through accounts payable. Most growing businesses need to tie up increasing
amounts of cash each year in this "working capital".
Finally, a few companies focus on "Free Cash Flow". This is best calculated as Cash Flow From Operations
before changes in working capital and minus sustaining capital spending that is necessary
to replace worn out assets. Free Cash Flow can also be stated as net income
plus depreciation minus sustaining capital
spending. This effectively replaces the accountant's non-cash depreciation with
the actual cash outlay to replace worn out assets.
Sustaining capital spending is the capital spending required to maintain
current operations. It should omit capital spending on major projects and
corporate acquisitions that are designed to boost growth and capacity beyond the current
level of operations.
Free Cash Flow is an excellent performance measure and is often superior to net
income as an indicator of value. In fact, forecast Free Cash Flow is the most
theoretically sound way to place a fair value on any company (and therefore 1
share of any company). If investors focus on Free Cash Flow then they are in
good company. Warren Buffett, the world's richest investor uses historic and
forecast Free Cash Flow to value the businesses that he buys.
Technically, Free Cash Flow often includes the change in working capital and
all capital spending. This definition of Free Cash Flow is used by business
valuators and is forecast for a period of years. In this manner, all investment
spending is considered and so is the cash flow that results from the total
When calculating Free Cash Flow for a single year, it is best to omit
the change in working capital and discretionary, non-maintenance capital
spending because the ultimate pay-off from those investments is not yet included
in operating cash flow. For this reason, Free Cash Flow for a single year is
calculated as Operating Cash Flow before the change in working capital less
sustaining capital spending.
Free Cash Flow is the only version of Cash Flow that investors should accept
as a substitute for net income.
Unfortunately most companies and analysts do not directly provide the Free
Cash Flow figure. But it can often be approximated as Operating Cash Flow
(before changes in working capital) less
total capital investments. However, large capital spending amounts
designed to materially expand the scope of operations including spending on
corporate acquisitions should be omitted if it can be identified. In addition
Cash Flow from Operations should ideally be adjusted to remove any material
unusual or one-time items.
In many cases good old GAAP net income is a better estimate of Free Cash Flow
than is so called Cash Flow due to the omissions noted above. This is
particularly true in cases where depreciation is roughly equal to the capital
spending that is required in an average year or quarter to replace worn out
However, there are some notable situations where net income is systematically
less than Free Cash Flow. In those cases a focus on Free Cash Flow could lead to
identification of stocks that deserve a high P/E ratio and could lead to some
bargains if the market is focusing on net income.
Certain asset intensive industries tend to have large and continuously
growing amounts of deferred tax. GAAP net income treats this as an expense since
it can theoretically reverse and have to be paid. In reality some companies
defer these amounts indefinitely and so Free Cash Flow is systematically greater
than net income for this reason.
In addition certain industries have very long lived assets that will not need
to be replaced for many years. GAAP net income charges an annual depreciation
expense which is often a reasonable estimate of required capital spending to
replace worn out assets. But in cases where assets will not be replaced for many
years, the present value of that eventual capital spending may be minimal and
again annual Free Cash Flow is systematically greater than net income.
Also accounting net income always assumes the company is a going concern and
that therefore capital assets will in fact be replaced as they wear out or as
resources are depleted. However some companies such mines and large oil and gas
deposits may be worth more as wind-down operations. In a wind-down operation
Free Cash Flow tends to systematically exceed net income.
In conclusion Free Cash Flow is a superior performance and value indicator,
but only if investors take the time to understand it and how to calculate it
properly. The so called Cash Flow that most companies and many analysts quote is
flawed as a measure of the true Free Cash Flow that a company is generating
because it usually omits the necessary capital spending to replace worn out assets. Investors should
ignore those flawed versions of Cash Flow. In most situations investors should
simply focus on net income. However, investors should calculate and focus on
Free Cash Flow in those cases as identified above where Free Cash Flow tends to
systematically exceed net income.