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FREE CASH FLOW

Free cash flow – refers to cash that is available for distribution to creditors and
stockholders because it is not needed for working capital or fixed asset investments.

“Perhaps the most important item that can be extracted from financial statements is the
actual cash flow of the firm…in practice, there is some variation in exactly how free cash
flow is calculated.”1

Note: Net Income ≠ Free Cash Flow

Cash flows received from the firm’s assets (i.e. operating activities)
= cash flow to creditors + cash flows to equity investors

Total Cash Flow of the Firm (Corporate Finance, 8th ed. by Ross, Westerfield, & Jaffe)

Total cash flow of the firm = Operating Cash Flow - adjustments for capital spending
and additions to net working capital.2

Formula: Staples (2007):

Operating Cash Flow 1,360,465
- Capital Spending - 555,026
- ∆ in Net Working Capital - (-21,658)
= Total Cash Flow of the Firm = 827,097

Step 1: Cash Flows from Operations

Operating cash flow – measures the cash generated from operations (i.e. business
activities like the sale of goods and services). It reflects tax payments, but does not count
capital spending or working capital requirements.3

Formula: Staples (2007):

EBIT 1,519,138
+ Depreciation + 339,299
- Tax - 497,972
= Operating Cash Flow = 1,360,465

Note:
Operating Cash Flow = NOPAT + depreciation

1
Source: Corporate Finance, 8th edition by Ross, Westerfield & Jaffe; p. 29-32.
2
When firms are growing rapidly, spending on inventory and fixed assets may be higher than operating
cash flow – causing this figure to be negative.
3
This is the cash the firm is generating to pay operating costs (generally positive).

1
 where, Net Operating Profit After Tax (NOPAT) = EBIT (1 – tax rate)

Step 2: Calculate Capital Spending

Capital spending – measures changes in net operating long term assets (i.e. plant,
property, and equipment), the figure represents the acquisition of fixed assets minus the
sale of fixed assets.

Formula: Staples (2007):

Ending PPE 1,974,121
- Beginning PPE - 1,758,394
+ Depreciation + 339,299
= Capital Spending = 555,026

Step 3: Calculate the Change in Net Working Capital4

Formula: Staples (2007):

Ending ∆ (Current Assets
- Current Liabilities) (4,431,363 – 2,788,383)
- Beginning ∆ (Current Assets - (4,144,544 – 2,479,906)
- Current Liabilities)
= ∆ in Net Working Capital = -21,658

Total cash flow of the firm = Operating Cash Flow - adjustments for capital spending
and additions to net working capital.5

Formula: Staples (2007):

Operating Cash Flow 1,360,465
- Capital Spending - 555,026
- ∆ in Net Working Capital - (-21,658)
= Total Cash Flow of the Firm = 827,097

The author’s note: “A firm’s total cash flow sometimes goes by a different name, free
cash flow.”6

4
The change in working capital is usually positive in a growing firm. The book uses a simple example
(that I follow here). It is important to note that changes in working capital should be more closely
examined.
5
When firms are growing rapidly, spending on inventory and fixed assets may be higher than operating
cash flow – causing this figure to be negative.
6
Source: Corporate Finance, 8th edition by Ross, Westerfield & Jaffe; p. 32.

2
Comments on Change in Working Capital

While the formula discussed above offers a general guideline for calculating the cash
flow to the firm. In practice several adjustments are typically made to the basic equation.

Remember FCF calculates the money that is available “for distribution to all of the
company’s investors, including creditors and stockholders.”

– Let’s look at the change in working capital a little more closely…

– Short-term investments are not WC.
⚫ ST investments are typically a result of investment decisions made by
the treasurer.
⚫ ST investments sometimes represent capital that is “parked” for an
acquisition or major capital investment.

Note: When you are uncertain about an item, ask yourself whether it is a natural
consequence of operations or a discretionary choice (i.e. a method of financing or
investment in a financial asset). If it is a discretionary choice, it is NOT an operating
asset or liability.7

Example: Staples’ 2007 Balance Sheet

7
Source: Financial Management,12e by Brigham & Ehrhardt, Chapter 3, pp. 96-97

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PERIOD ENDING 3-Feb-07 28-Jan-06 29-Jan-05
Assets
Current Assets
√ Cash And Cash Equivalents 1,017,671 977,822 997,310
X Short Term Investments 457,759 593,082 472,231
√ Net Receivables 861,905 725,929 571,167
√ Inventory 1,919,714 1,706,372 1,602,530
X Other Current Assets 174,314 141,339 138,374

Total Current Assets 4,431,363 4,144,544 3,781,612

Long Term Investments - - -
Property Plant and Equipment 1,974,121 1,758,394 1,600,874
Goodwill 1,455,113 1,378,752 1,321,464
Intangible Assets 265,962 275,280 260,920
Accumulated Amortization - - -
Other Assets 270,706 119,619 106,578
Deferred Long Term Asset Charges - - -

Total Assets 8,397,265 7,676,589 7,071,448

Liabilities
Current Liabilities
√ Accounts Payable 2,587,206 1,754,786 2,195,617
X Short/Current Long Term Debt 201,177 2,891 1,244
X Other Current Liabilities - 722,229 -

Total Current Liabilities 2,788,383 2,479,906 2,196,861

Long Term Debt 316,465 761,032 736,077
Other Liabilities 252,657 - -
A more accurate calculation for the change in Net Working Capital
8,986
for Staples
5,845
is23,314
shown
Deferred Long Term Liability Charges
below.
Minority Interest 9,109 4,335 -
Negative Goodwill - - -
2007 2006
Total Liabilities 3,375,600 3,251,118 2,956,252
Cash 1,017,671 977,822
A/R
Stockholders' Equity 861,905 725,929
Inv. 1,919,714
Misc Stocks Options Warrants 1,706,372 - - -
A/P 2,587,206
Redeemable Preferred Stock 1,754,786 - - -
Preferred Stock - - -
Accruals
Common Stock 510 498 325
Retained Earnings 1,212,084 1,655,337 4,005,424 3,529,170 2,818,163
Treasury Stock -2,511,796 -1,735,974 -1,072,829
Capital Surplus
Updated: Calculate the Change in Net Working Capital 3,338,412 2,544,692 2,255,110
Other Stockholder Equity 189,115 87,085 114,427

Total StockholderFormula:
Equity Staples 5,021,665
(2007): 4,425,471 4,115,196
Ending ∆ (Cash + A/R + Inv.
Net Tangible Assets $3,300,590 $2,771,439
- A/P +Accruals) 1,212,084 $2,532,812

- Beginning ∆ (Cash + A/R + Inv. - 1,655,337

- A/P +Accruals)
= ∆ in Net Working Capital = -443,253

Updated: Free Cash Flow

Formula: Staples (2007):
Operating Cash Flow 1,360,465

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 - Capital Spending - 555,026
- ∆ in Net Working Capital - (-443,253)
= Total Cash Flow of the Firm = 1,248,692

This is consistent with the formula in Financial Management, p. 101 (shown below)
FCF = EBIT(1 – tax rate)
NOPAT
Operating CF
+ depreciation
(cash + A/R + inventories)
- Gross investment Net investment - (A/P + accruals) net
in operating capital in operating capital + Operating long-term plant
+ depreciation assets
∆ & equip.
Note: EBIT (1 – tax rate) = NOPAT
2007 2006
≈ EBIT – Income Tax Expense
Cash 1,017,671 977,822
= 1,519,138 – 497,972 = NOPAT = 1,021,166
Operating CF = NOPAT + depreciation A/R 861,905 725,929
= 1,021,166 + 339,299 = 1,360,465 Inv. 1,919,714 1,706,372
Net investment in operating capital A/P 2,587,206 1,754,786
= 3,186,205 – 3,413,731 = -227,526 Accruals
Gross investment in operating capital PE 1,974,121 1,758,394
= -227,526 + 339,299 = 111,773 3,186,205 3,413,731
FCF = 1,360,465 – 111,773 = 1,248,692