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.
