FCF is supposed to represent owner's earnings, or NP. It is what is leftover for investors after cash that the business has consumed.
The reason why we deduct Depreciation from OCF to arrive at FCF, is because you are accruing the future expense of the NCA you will eventually have to replace, if you want to maintain the same productive capacity of the business. Or you are accruing the upfront cost of the NCA made in the past into the current period that it is being used in. Both philosophies work. We call this maintenance CAPEX, because it's just for the purpose of maintaining productive capacity.
When people colloquially refer to CAPEX, they are referring to growth CAPEX. This represents investments made to generate future productive capacity, hence it should be accrued in future periods. You can also imagine it being the maintenance CAPEX of future years.
Hence FCF = OCF - depn; not OCF - CAPEX.
If you have trouble picturing it, imagine you run a photocopy business.
You pay $10 upfront to buy a photocopy machine which has a useful life of 10 years, and it earns you $2/yr.
Your actual cash profit is $1/yr, because you have to account for the $10 depreciation you've spent upfront spread out over 10 years.
But if you buy a second photocopy machine in year 2, your unit cash profit doesn't become $0/yr ($2 - $2). It's still $1/yr. ($2 - $1)
Hey so I know it's 3 years late but this is wrong. FCF is OCF - capex. Capex does not colloquially refer exclusively to growth capex. Owner earnings is along the lines of EBIT - maintenance capex, which is almost the opposite of OCF - depn, in a funny way.
Hey thanks for pointing it out! I have corrected the error and added an edit note at the end of the article. Fortunately it doesn't really change the overarching narrative of the original article.
2020 inventory 1666, 2019 919, so ideally change in inventory is - 747, but in the cash flow it's - 465 for 2020. I maybe wrong. Just trying to understand.
Yes I noticed that as well. Sometimes there are some accounting adjustments and the figures won't line up exactly, which may be exacerbated by the high inventory balances. But unless the difference is onerous you can usually just ignore it, as the objective of the investor is to gain margin of safety rather than precision.
Hi Aaron, appreciate if you can point out how do you get the 'inc. in borrowings' and 'inc. in CAPEX' figure. Thank you for the analysis
It's the YoY change of Borrowings and CAPEX respectively
Congratulations! Very interesting! I subscribed and added you on Linkedin
Thank you!
Hello how did you calculate your inventories, receivables, payables, and contract asset figures under WC?
They should be the figures as they appear on the balance sheet
Hi do you conduct course on valuation? DCF etc
Sorry I don't
How do you get fcf?
FCF = OCF - depreciation
sorry, new to this. but I have read somewhere else FCF = OCF - CAPEX. Mind sharing how it works really?
FCF is supposed to represent owner's earnings, or NP. It is what is leftover for investors after cash that the business has consumed.
The reason why we deduct Depreciation from OCF to arrive at FCF, is because you are accruing the future expense of the NCA you will eventually have to replace, if you want to maintain the same productive capacity of the business. Or you are accruing the upfront cost of the NCA made in the past into the current period that it is being used in. Both philosophies work. We call this maintenance CAPEX, because it's just for the purpose of maintaining productive capacity.
When people colloquially refer to CAPEX, they are referring to growth CAPEX. This represents investments made to generate future productive capacity, hence it should be accrued in future periods. You can also imagine it being the maintenance CAPEX of future years.
Hence FCF = OCF - depn; not OCF - CAPEX.
If you have trouble picturing it, imagine you run a photocopy business.
You pay $10 upfront to buy a photocopy machine which has a useful life of 10 years, and it earns you $2/yr.
Your actual cash profit is $1/yr, because you have to account for the $10 depreciation you've spent upfront spread out over 10 years.
But if you buy a second photocopy machine in year 2, your unit cash profit doesn't become $0/yr ($2 - $2). It's still $1/yr. ($2 - $1)
Hey so I know it's 3 years late but this is wrong. FCF is OCF - capex. Capex does not colloquially refer exclusively to growth capex. Owner earnings is along the lines of EBIT - maintenance capex, which is almost the opposite of OCF - depn, in a funny way.
Aaron thanks for replying, never expected to get a so detailed answer. Anyhow I think the excel table looks a little weird.
Based on your excel table,
year = 2020 2019, 2018, 2017, 2016
OCF = 46, 221, 83, 85, 56
depn = -216, -143, -90, -69, -33
FCF = OCF-depn = -170, 78, -7, 16, 23
your excel table shows FCF of -170, -137, -137, -137, -137
Hey thanks for pointing it out! I have corrected the error and added an edit note at the end of the article. Fortunately it doesn't really change the overarching narrative of the original article.
Thank you Aaron, vary good analysis and reports.
Thanks
2020 inventory 1666, 2019 919, so ideally change in inventory is - 747, but in the cash flow it's - 465 for 2020. I maybe wrong. Just trying to understand.
Yes I noticed that as well. Sometimes there are some accounting adjustments and the figures won't line up exactly, which may be exacerbated by the high inventory balances. But unless the difference is onerous you can usually just ignore it, as the objective of the investor is to gain margin of safety rather than precision.
Hi, trying to understand the cash flow that you built. The chnage in in working capital on the P&L is not matching the COperating flow sheet
Sorry can you clarify what you mean?