What are free cash flows? The net income a business declares and the actual cash that it generates are two separate things. Since net income is not the same as the cash generated by the business, we need to make a few adjustments to the figure of net income to obtain the actual cash flow for the business in a particular year.
The adjustments are as follows:
- Find the operating income of the business. Operating income (EBIT) represents the amount of money the business has made after cost of goods sold and operating expenses have been deducted from the sales amount but before interest payments and taxes have been paid.
- Second, calculate the after-tax operating income. Since AMD has been running at a lost recently, the firm does not have to pay taxes.
- Add back non-cash charges to the net income. Non-cash charges are charges that were included as an expense, but have no cash impact. Depreciation and amortization are both non-cash charges. Both these expenses do not require a business to pay out any amount of cash.
- The calculation of net income does not include the cash impact of addition in assets required to produce that income. Neither does it include the short term financing provided by suppliers when they sell their products on credit, or by employees when salaries may accrue. The difference between these two items (current assets and current liabilities) is called the change in net working capital. A simple way to calculate this is to subtract the change in current liabilities from current assets. The figure obtained is then subtracted from net income.
- Working capital changes are short-term investments. Investments in long-term assets are called capital expenditures, capital expenses or capital investments. These are cash expenses that have not been included in the net income calculations and therefore are subtracted.
- Here is a summary of the last 5 steps. Starting with the tax operating income, we add back non-cash charges. Then we adjust for changes in net working capital. Finally we subtract the total capital investment.
- We have now arrived at the answer.
Calculation of free cash flows is shown below using the figures we have with us for AMD.
From the income statement we get the projected operating income
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
Operating Income | -3,220,520 | -3,616,183 | -3,952,471 | -3,658,049 |
As AMD does not pay taxes because it is running at a loss, it’s after tax-EBIT is the same as its Operating Income
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
After-tax EBIT | -3,220,520 | -3,616,183 | -3,952,471 | -3,658,049 |
From the income statement we get the projected depreciation & amortization. These are added back to After-tax EBIT
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
Depreciation & Amortization | 2,859,033 | 3,284,930 | 3,671,642 | 4,011,863 |
We then calculate the increase in current assets from one year to the next. ( Current Assets this year are subtracted from current assets of the next year)
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
Minus incr. in current assets | 104,594 | 68,826 | 60,981 | 107,165 |
We can also calculate the increase in current liabilities from year to year (i.e. current liabilities this year subtracted from current liabilities next year).
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
Plus incr. In Current liabilities | 89,386 | 62,570 | 72,213 | 76,556 |
After this, we calculate capital expenditures, which can be obtained by subtracting the figure of Gross fixed assets of the present year from Gross Fixed Assets of next year.
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
Less: Capital exp | 722,974 | 619,811 | 508,702 | 454,173 |
Putting all the information together, we get
Calculation of Free Cash Flows | 2000 | 2001 | 2002 | 2003 |
After-tax EBIT | -3,220,520 | -3,616,183 | -3,952,471 | -3,658,049 |
Add: Depreciation & Amortization | 2,859,033 | 3,284,930 | 3,671,642 | 4,011,863 |
Minus: Increase in current assets | 104,594 | 68,826 | 60,981 | 107,165 |
Add: Increase in Current liabilities | 89,386 | 62,570 | 72,213 | 76,556 |
CFO before capital expenditures | -376,695 | -337,509 | -269,597 | 365,046 |
Less: Capital expenditure | 619,811 | 508,702 | 454,173 | |
Free cash flow to debt + equity | -1,099,669 | -957,320 | -778,299 | -130,968 |