- Do analysts understand the definition and meaning of free cash flow [FCF]?
- Do they understand the quality of Amazon’s (AMZN) FCF?
- What is the most meaningful method to compute it?
- Should an increase in Current Liabilities be included in FCF, as is being done by most analysts?
Companies, analysts and investors understand the importance of FCF, but there is no real consensus on the definition FCF and of how to compute it. This allows for different results in the determination of FCF, as it varies depending on the definition used, and these variations will give different conclusions as to the performance of the company. In certain cases, adjustments should be made to the FCF figures so that a quality determination can be made .
Amazon is a company with substantial growth in sales, cash flow and liabilities. The following cash flow and free cash flow figures were published by Money Central on January 30, 2008 and are similar to the determination made by various analysts.
...Operating cash flow was $1.41 billion in 2007, compared with $0.70 billion in 2006. Free cash flow increased 143% to $1.18 billion in 2007, compared with $0.49 billion in 2006...
The FCF number of $1.18bn. is a great number, but does it accurately reflect the true picture of Amazon’s FCF? Does it consider the quality of what they are calling FCF and how much of the increase of what they are calling “FCF” is due to the increase in Current Liabilities? To answer these questions, you must understand what FCF is.
Definitions of Free Cash Flow
- "FCF is what a company has left over at the end of the year - or quarter - after paying for all the salaries, bills, interest on debt, and taxes and after making capital expenditures to expand the business.”
- “Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to owners (stockholders) of the capital employed in the company.” For a fundamental investor, this is a very important number because, if you owned this company outright, FCF is the money that you would get to withdraw for yourself.
- "IT IS DEFINED AS CASH WITHOUT ANY RESTRICTIONS ON IT USE. It is available for any purpose at any time."
Free cash flow in one year or period is almost meaningless without examining the QUALITY of the cash flow.
The quality of what many are adding to FCF should be questioned, as they are using funds left over from operations on a short term basis, BUT NOT AVAILABLE FOR DISTRIBUTIONS TO THE OWNERS in their computations of FCF. This cash is not FCF as it will be used to pay liabilities due shortly after December 31. This can be shown by reviewing Amazon’s Statement of Cash Flow for the March 31, 2008 quarter; it shows Cash From Operating Activities as a negative $645 million: this is because the December 31 liabilities were paid in that quarter.
It is true that Amazon had a substantial increase in Cash From Operations [CFO] for the December quarter; a portion of that is due to them getting paid for products by customers before they have to pay suppliers for the goods sold. This $100s of millions of cash is temporarily held and invested, and gives Amazon a substantial amount of investment income, but this cash should not be considered FCF.
In comparing Amazon’s December 2006 and 2007 balance sheets, total Current Liabilities increased from $2.5 billion in 2006, to $3.7 billion in 2007 an increase of $1.2 bn. or 46.7% which is much greater than the Sales increase of 38.5% for the year. In regards to the Statement of Cash Flow, as accounts payables and Current Liabilities increase, Cash Flow from Operations [CFO] increases. If a company can stretch out the time it takes to pay its bills at year end, this will increase the Cash From Operations figure and depending on the formula used to compute FCF, that figure also. This short-term "increase" in cash is simply a result of not paying out the cash that is owed by the company. In other words, the effect is temporary and can overstate the cash that the company appeared to receive from operations during the year. In the long run, the changes will vanish (as can be seen in the March 31, 2008 CF Statement). That is why adjustments should be made to both the CF and the FCF figures.
The following is a partial list of the definitions of FCF currently in use, as listed in an article in the NY CPA Journal; similar definitions can be found on Investopedia and Wikipedia.
- Cash provided by operations less capital expenditures
- Cash provided by operations less capital expenditures and dividends paid
- Net income plus depreciation less capital expenditures
- EBITDA less capital expenditures
The following, from above, are two examples of basic formulas, to compute FCF for the 12 months ended 12/31/07:
(This is a formula commonly used by many analysts and the method Money Central published that I listed above. This method ignores the quality of the FCF and includes the increase of liabilities in the FCF total. The Statements of Cash Flow can be found on Yahoo Finance.)
Cash Flow From Operations.......$1.405 bn.
- Less Capital Expenditure............224
- Free Cash Flow................................$1.181bn
- Plus Depreciation.........................246
- Less Capital Expenditures..........-224
- Free Cash Flow.................................$496 ml
As can be seen from the above two computation, there is a substantial difference in determining FCF. Since there is no real consensus on the definition FCF or CF adjustments are usually made to the figures depending on what the purpose of the analysis is and the formula used. If you were buying a business, you would want to know what the FCF is to aid in determining a purchase price.
Free Cash Flow, strictly speaking, is the amount of money left over from the operations of a company that is available for distribution to owners (stockholders) of the capital employed in the company.
A buyer of a business would not consider a temporary increase of cash held to pay Current Liabilities FCF. It is a source of investment income, but it is not available for distribution to the owners and is not FCF.
Disclosure: Author has a short position in AMZN