We know accountants can be a little delusional at times, but more than that, we know that accounting profits are delusory all the time. For example, Net Profit after Tax (NPAT) is an accounting construct; it is based on a range of policy decision that don’t reflect reality. These delusory policy decisions determine revenue recognition, inventory reporting and depreciation scheduling. The implication of this disconnection from reality is that accounting profits rarely act as an input to the real value of a business.
Private equiteers stand by the idiom money talks, bullshit walks. And, in referring to money, I mean cash. With cash, a business can pay dividends, repay debt, invest in assets and absorb increases in input cost. With accounting profits, all a business can do is calculate its tax liability (which is important in other ways, but more on that in another post). So, what’s the purpose of explaining this? Well, a private equity investor will rarely even acknowledge the NPAT of a potential investee. This is because if a deal goes ahead, capex, depreciation, interest expense and taxation will all change.
This is where Free Cash Flow analysis (Free Cash Flow analysis) makes an appearance. Free Cash Flow analysis attempts to measure the cash that is free for the business to use for dividends, capex, debt repayment, etc. I’m certainly not suggesting Free Cash Flow analysis is the perfect measure, because it’s not, but it is far better than relying on NPAT. There are numerous Free Cash Flow analysis calculations, but the most common is as follows:
What’s happening here, in a practical sense, is that we’re taking NPAT, adding back depreciation and amortization (which are non-cash items), adjusting for accrued (rather than paid) revenues and expenses, and then taking away capital expenditure (which is a cash item). In theory, the result is the real cash profit for the business. To value the business, Free Cash Flow analysis may underpin a Discounted Cash Flow (DCF) analysis or earnings multiple calculation (more on this later).
This is just a primer on Free Cash Flow analysis; in another post I’ll talk about the issues with Free Cash Flow analysis, some solutions to these issues, and the caveats of using Free Cash Flow analysis in business valuations; there may be a more suitable measure.