"[O]utstanding businesses by definition generate large amounts of excess cash. --Warren Buffett letter to shareholders from 1984

However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash. --Warren Buffett letter to shareholders from 1980

The above quotes stress the importance of finding businesses that can consistently turn net income (earnings) into free cash flow (FCF). The reason for this is because net income is an accounting number used for reporting purposes, but free cash flow is the actual amount of cash available to investors. More specifically, free cash flow is the amount of cash that a company generates after spending on capital expenditures (property, plant, and equipment) to maintain and grow its assets. The cash can be used to reinvest back into the business, pay dividends, buy back stock, pay down debt, or make acquisitions. Any unused free cash can be used to increase the cash on the balance sheet.

One way to calculate free cash flow is by subtracting capital expenditures from operating cash flow. So, before calculating free cash flow, we should understand how to reconcile net income to cash flow from operations. This article will explain some common adjustments that are used in the reconciliation process.

A man studies a financial report projected on a wall.

Image source: Getty Images.

Let's first quickly review the income statement because the calculation of operating cash flow starts with net income:

Sales (revenue) is the "top line" of the income statement.

minus cost of goods sold

= gross profit

minus operating expenses

= operating income (also called "earnings before interest and taxes")

minus interest expense (so debt holders are the first to get paid)

= earnings before taxes

minus taxes (the government is second in line to get paid)

= net income (shareholders are last to get paid)

Net income, which is the "bottom line" of the income statement then becomes the top line of the cash flow statement. Now we will look at some of the adjustments that are made to net income to calculate operating cash flow.

  1. Add back depreciation and amortization because these are noncash charges, meaning the company does not actually pay out any cash.
  2. Add back stock-based compensation because it is paid in shares, not cash, so it is also a noncash expense.
  3. Subtract an excess tax benefit from stock-based compensation. When an employee exercises an option, the company can (deduct) write-off the gain because options are considered a form of compensation and employee compensation is considered a business expense for tax purposes. This deduction increases reported earnings (net income), but no cash actually enters the business so it is subtracted on the cash flow statement.
  4. Subtract a gain on sale of property, plant, and equipment or other assets (like patents) because assets sit on the balance sheet and not the income statement. Since the assets do not reside on the income statement, no adjustment is made to net income.
  5. Subtract deferred tax assets because these represent taxes the company pays out now but will not owe later. Since cash is paid out now, it is subtracted on the cash flow statement.
  6. Add back deferred tax liabilities (also called "deferred income taxes") because these are taxes the company will pay out at a later date. Since no cash is leaving the business today, we need to add it back on the cash flow statement.
  7. Subtract an increase in accounts receivable. Accounts receivable is payment owed to a company that it has not yet received in cash. Since the company has not yet received the cash, it is subtracted on the cash flow statement.
  8. Add back a decrease in accounts receivable because it means the company is receiving cash from those customers that purchased on credit. This means cash is entering the business so it is added back on the cash flow statement.
  9. Subtract an increase in inventory because purchasing inventory is a use of cash.
  10. Add back a decrease in inventory because less inventory sitting on the shelves or in the stock room frees up cash.
  11. Add back an increase in accounts payable because accounts payable is a line item representing money the company owes to its suppliers. If accounts payable increases, then the company is taking longer to pay its suppliers, meaning no cash is leaving the business so it is added back to calculate operating cash flow.
  12. Subtract a decrease in accounts payable because this indicates cash left the business when the company paid off some of what it owes to its suppliers.
  13. Add back deferred revenue. Deferred revenue is cash collected up front for a product or service that has not yet been delivered to the customer (like a yearly newspaper subscription), and therefore has not yet been recorded as revenue on a company's income statement. Because it is not recorded as revenue (the top line), it has no impact on net income (the bottom line). Rather, the cash inflow is recorded as a liability on the company's balance sheet at the time cash is received (since the company still owes a year's worth of newspaper delivery) and is added back to net income on the cash flow statement because the company did, in fact, receive cash. The deferred revenue is recognized on the income statement over the life of the contract as it is earned.

After making some or all of these adjustments (and possibly a few more) a company will report a line item called "cash generated by operating activities." This is also sometimes called "cash flow from operations" or "operating cash flow."

The final step is to subtract the capital expenditures line item, which is sometimes called "property, plant, and equipment," and can be found on the cash flow statement, from operating cash flow to calculate free cash flow.

Below is a screenshot of Apple's (AAPL -0.66%) cash flow statement from its fiscal year 2013 10-K. You will notice that Apple made some of the adjustments discussed above including adding back depreciation and amortization, stock-based compensation, deferred revenue, and deferred income taxes, and making adjustments to working capital accounts (accounts receivable, inventory, and accounts payable) based on whether those account balances increased or decreased from the prior year (info you can find on Apple's balance sheet).

In 2013 it generated $45.5 billion in free cash flow, which is calculated as cash generated by operating activities of $53.666 billion minus property, plant, and equipment of $8.165 billion. Apple's free cash flow far exceeds its net income of about $37 billion (for a FCF to net income ratio of about 1.2 times) qualifying Apple as a free cash flow machine.

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