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I wanted to jump in again on this string over on What The Heck Is CROIC? There seems to be some confusion as to how free cash flow and GAAP earnings are related and I figured that this would be a good topic rather than let it get buried in the comments.

Do GAAP earnings drive free cash flow? Or, does free cash flow drive earnings?

The Accounting

Businesses can have very complex accounting practices. Still, whether you are looking at business finances or personal finances, the basics are the same. No matter what you report to the IRS—no matter how good (or bad) you look on paper—you or your business will financially survive, thrive, or die based on how much cash you can generate.

Let's break down a simple example of how dollars flow through a fake business:

  1. Company spends $20,000 marketing its consulting service.
  2. $200,000 flows into the bank because customers paid for consulting services.
  3. $100,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
  4. $80,000 is left in the bank at the end of the year.

Uncle Sam Wants His Cut

Tax time. Our business has to file its return. What wasn't shown in the above is a "depreciation" expense—a write-off that the company is allowed to take based on a prior purchase of equipment. For the sake of simplicity, let's assume the company won't have to re-buy or replace that equipment for the next two or three years.

On its tax return, the company shows:

  1. $200,000 of revenue,
  2. $120,000 of expenses that required cash,
  3. $20,000 of depreciation—even though it didn't require cash and doesn't appear in the above report.

As far as Uncle Sam is concerned, our business had a taxable income of $60,000. In the US, this company would pay $10,000 in taxes (2006 rates) leaving it a net income of $50,000.

Net Income Vs. Free Cash Flow

To calculate free cash flow, we have to follow the cash. In practice, we simply add that depreciation back in to the net income (along with some adjustments). In reality, the actual free cash flow calculation would start with revenue and subtract any cash expenditures:

  1. $200,000 of revenue
  2. - $120,000 of cash expenditures
  3. - $10,000 of taxes paid in cash

For this company, free cash flow would be $70,000 even though net income reported to shareholders and the IRS was $50,000.

Question: What Drives What?

Does free cash flow drive earnings? Or vice versa? Here's the reality: No matter what the earnings were for the year—no matter how creative or conservative the company was with its accounting—this business has $70,000 in cash that it can use to grow.

What will it do? Well, we saw that it previously spent $20,000 on marketing to generate $200,000 of revenue. Assuming it wanted to (and could) repeat that performance, the business would invest that full $70,000 in marketing to generate $700,000 in revenue—assuming it was that easy!

Answer: Free Cash Flow Drives Earnings

A year passes, and our business used that $70,000 for marketing. Here's how the year played out:

  1. Company spends $70,000 marketing its consulting service.
  2. $700,000 flows into the bank because customers paid for consulting services.
  3. $350,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
  4. $280,000 is left in the bank at the end of the year.

Again, we pay the piper. After deducting another $20,000 in depreciation, Uncle Sam collects $84,650 in taxes. Net income comes in at $175,350; free cash flow is $195,350.

The Key Is Cash Flow

Why did earnings increase? Simple: The company generated enough cash to fuel earnings. Had our business only generated $20,000 in excess cash, it would have only had $20,000 to spend on marketing and we could have only expected around $200,000 of revenue (or a $200,000 increase depending on whether or not past customers were buying again).

Creative Accounting

Yes—businesses can mess with their accounting to look better or worse than they are. Still, no matter what our business did to its tax return figures and net income, it had exactly $70,000 to fuel growth. Could the executives have stolen that cash and screwed with shareholders? Perhaps. Still, if that is the number one reason you are scared to buy stocks, you certainly shouldn't be in the markets in the first place.

† Non-U.S. readers: Uncle Sam is a reference to the US Government and/or the US Internal Revenue Service [IRS].

Source: From Free Cash Flow to Earnings and Back