JAMES P. WESTON: Hi, welcome back to finance for non-finance professionals.
This week, we're talking about free cash flows.
How to measure how much cash creation is really going on
by walking through the financial statements
and figuring out where it's all hidden.
In this lesson, we're going to talk about depreciation and capital
expenditures and how to adjust our free cash flow member to reflect those.
What is depreciation and amortization?
Depreciation and amortization is the real wear and tear
that happens to our machinery, to our real, physical property, plant,
and equipment as we use it.
As we use machines, or buildings, or land, they kind of wear.
They kind of wear down.
They kind of depreciate.
They lose value.
As they lose value, what does that mean?
That's an expense because eventually we're going to have to replace it.
But we haven't replaced it yet.
And so what we're going to write down in the income statement
is the fact that the assets have gone down.
We're going to take it as an expense.
But it's a non-cash expense.
If I have a machine, and the machine gets rusty
and it's a little bit creaky but I haven't fixed it or replace it yet,
it's not like there's cash going out of the firm.
But in the income statement, I'm going to take a depreciation expense.
That's a non-cash expense, which means I'm writing it down as a reduction
in my net income, or my profits, or my earnings,
but it's not actual money that's left the firm.
It's just an accounting term that reflects the economic depreciation
but it's not actual cash.
So you can see that it's going to create a wedge between accounting
earnings and actual cash flow.
Amortization is the same thing, but it's like an intangible,
a brand value that might lose value or gain value over time.
We're going to write that down as an expense too.
OK.
Those are included in earnings but what they aren't is real cash.
And so, what we're going to go back and do is try to undo them.
On the other hand, the sort of the parallel to depreciation
is money that I actually spent on new assets.
Buying or replacing long term assets.
Any increase in net property, plant, and equipment is capital expenditures.
CAPX is spending-- sometimes really big spending--
but I don't report it in earnings.
Why don't I report it in earnings?
Because it's not really a reflection of the ongoing cost of generating
the sales, which is what I'm writing down in the profit and loss statement.
But it is real money going out and so I write it down on the balance sheet.
And so what we want to do is undo these two things.
What the essential idea is that I'm going to take depreciation,
and I'm going to add it back in because it never really left.
I'm going to take capital expenditures or any increase
in physical property, plant, and equipment,
and I'm going to subtract it off of net income or profit.
So I'm going to add back depreciation, subtract off capital expenditures.
Now, let's talk for a minute.
Why do accountants do this?
Why are they doing this to us?
They're pretending that we're spending things
that we're not actually spending.
And then we're spending a whole bunch of money
that I'm not telling you about in profit or earnings.
The idea here is that, from an accounting perspective,
this is actually the right thing to do.
It actually gives me a better, more transparent report
on the financial condition of the company
by taking that CAPX and what I'm going to do with that CAPX is spread it out.
Like butter over a piece of toast, I'm going to spread it out
over the useful life of the asset.
So I'm going to tell you that I spent the money,
but I'm going to tell you that I spent the money on the assets
as those assets generate revenue over their life.
So I'm going to match the duration of the asset
to the duration of the revenues, by spreading that expense over.
So I am going to tell you, from an accounting perspective,
how much money I spent on these assets.
But I'm going to tell you about it in a whole series of depreciation expenses
that get spread out over time.
So that's a nice thing to do from an accounting perspective
because it reflects sort of the ongoing cost of doing business.
But from a cash perspective, it's dead wrong
because it's not telling me how much cash really left or came in.
So we're going to make those two adjustments to net operating profit
to reflect real cash coming in and not being expensed.
So CAPX needs to be subtracted for free cash flow.
So let's go back and recall.
We're going to take operating profit after tax,
we're going to subtract the increase in working capital, which we talked about
in a previous lesson.
We're going to add back depreciation because that money never really left.
We're going to subtract off capital expenditures.
And then, in our next lesson, we'll talk about salvage values.
All those things together are going to give us
our measure of free cash flow or real cash creation through the accounting
statements.
OK.
To sum up, depreciation and amortization is a non-cash expense
that's reflected in earnings but doesn't reflect the real cash movement.
We're going to add it back for purposes of free cash flow.
Capital expenditures are a real cash outflow that
aren't reflected in profit or earnings.
We're going to simply subtract that out to make sure the free cash flow
accounts for CAPX.
So accounting for depreciation and CAPX are relatively easy,
but we've got to make sure that we do it when we're constructing
our measures of free cash flow.
James WestonHouston Endowment Professor of Finance
