A reader has tweeted:
@djthomas Is any chance to make a tutorial about how to determine Free Cash Flow (FCF) from financial statements on your website?
— Manoz Joshi (@ManozJoshi) June 2, 2013
I like a challenge and so I’ll get straight into it.
Free Cash Flow – A Quick Tutorial
The problem starts with just which free cash flow formula you would like to use.
Investopedia explains that free cash flow can be calculated in two ways:
- EBIT (1- tax rate) + depreciation and amortization – change in net working capital – capital expenditure.
- Operating cash flow – capital expenditure.
Another problem is the accounting jargon as well as the freedom with which managements are allowed to book expenditure as capital expenditure.
One of the reasons why I’m such a fan of The Intelligent investor by Ben Graham is because of it’s simplicity, especially in terms of the investing strategies that can be used ‘straight out of the box’ as well as the simplicity of the formulas Graham advocates investors to use such as the humble PE ratio or Net Current Asset Value.
I’ll take my cues from Graham and use a simple formula for the calculation of free cash flow:
Time to kill some jargon.
Operating cash flow
This beauty can also be referred to as Cash Flow From Operations or Cash Flow From Operating Activities. In a nutshell, it is all the cash generated by a company excluding specific costs associated with long term investments and investments in securities such as stocks.
Sometimes shortened to ‘capex’ or referred to as ‘maintenance capex’. Examples includes purchases such as fixed assets known as PPE (Plant, Property and Equipment) and in some cases investments in intangible assets. Investopedia defines PPE as:
A company asset that is vital to business operations but cannot be easily liquidated.
Now that I’ve confused you, lets actually look at a cash flow statement to apply our knowledge to a real life example.
The Tesco Cash Flow Statement 2013
Turning to page 72 will give you Tesco’s Group Cash Flow Statement, a section of which is provided below:
Note the line that says cash generated from operations of £3,873m – this is the operating cash flow figure we need for the formula we are following.
To find the capital expenditure figure is a little trickier but is made easier by using the pdf version of the Tesco 2013 annual report – simply press CTRL and F, type in ‘capital expenditure’ and click ‘next’ and you will eventually end up on note 2 to the accounts on page 86 as shown below:
As you can see, PPE comes to a total of £2,639m and there is also investment property (£43m), goodwill and other intangibles (£372m) that brings total capital expenditure to £3,054m.
Operating Cash Flow (£3,873m) minus Capital Expenditure (£3,054m) = £819m.
Hopefully you’ve followed along with this post by referring to the Tesco Annual Report for 2013. Don’t worry if this post has confused you since many financial websites do the number crunching for you and provide free cash flow information – for free :).
In part 2, I’ll share some examples of how to use free cash flow to value a company and the use of financial websites to do so. In the meantime, if you like learning how to number crunch from a value investor’s perspective, check these posts out:
- The PE (Price to Earnings) Ratio
- How To Value A Company; The Lazy Investor’s Guide
- Do You Make This Classic Investing Mistake?
Image: Dollars Funnel