JAMES P. WESTON: Hi, welcome back to finance for non-finance professionals. In this video, we're going to talk about hunting through the financial statements for cash creation, and we're going to come up with our measure of free cash flow. Let's start off with the fact that earnings-- accounting earnings or net income-- is not cash-- those can be two separate things. A firm might have really high earnings, but not have any cash. And we're going to think about why that might be or what could possibly be going on, where a firm could be profitable, but not have any cash. One of the reasons is that accruals-- or what accountants call when they book sales. They book sales sometimes before the cash actually comes in. So that might be one reason why there's some slippage between accounting earnings and actual cash. Accountants also write down things-- accounting is more of a historical record of what's happened, and so a lot of times accountants will write down things that their book value, or what they paid for something maybe 20 years ago that might not be related to what it's worth in the market today. That difference, or that slippage between book value and the market value of an asset, could also create a difference between earnings and cash. The other thing is that accounting costs are not always equal to real economic costs. For example, I might have a machine that I take a depreciation expense on, in other words, I write down the fact that the machine has devalued. But it's actually the same machine. It hasn't gone down in value. It hasn't deteriorated. It hasn't fallen apart. But I take the depreciation expense anyway for tax purposes. Well, that also will create a slippage between actual cash going out of the firm, and real economic cash-- whether actual dollar bills are being created or lost. So we'll start off with the fact I can't spend earnings. It's not actual cash. I can't pay it out as a dividend. There are some non-cash expenses that we write down. That's a funny thing, right? Non-cash expense. Sometimes for accounting purposes-- for good reasons, from an accounting perspective-- we'll write down an expense against revenues, but there's no actual cash leaving the business because of that expense. So we'll detail where that happens and try to unroll it and get back to our measure of cash. Sometimes accountants write down extraordinary items. They'll say, we made a lot of money this quarter, except that we don't have any money, because we wrote down an extraordinary cost that was a one-time only cost, and so we don't have to book it as an expense, we're just going to subtract it off at the end after we've reported earnings. That's a funny thing, and we'll have to try to undo that as well. There are also changes in the balance sheet of how much stuff I have-- assets that I've bought or sold that don't get written down on the income statement. Therefore, they don't get recorded at bottom-line net income or earnings, but there's actually a huge cash outflow because of money I spent, or cash inflow because of stuff but I sold. We'll have to go back and sweep that up, as well. The idea here is that we're going to walk through each of the items in the income statement, balance sheet, and statement of cash flows, in order to find cash-- actual dollar bills-- that we can get our hands on to give to investors. In the end, like we talked about in weeks one and two, the only thing that matters is actual cash-in-hand from an investor's perspective. And not all cash is paid out, so we need a measure of cash creation that's consistent with the financial statement recordings and can be used across different firms. So we'll talk about best practices for measuring cash creation, and what we're going to come up with is this measure of free cash flow. Free cash flow is going to tell me how much money I could scrape out of the business in total-- that I could, I may not want to, but I could if I wanted to pay out to investors. It may be that I take all that free cash flow and pump it right back into the business to buy more assets, but that free cash flow means how many dollar bills could I scrape together and pay out to financial investors if I wanted to. I may not do it, but free cash flow or FCF is going to give us our measure of how much cash creation is really going on through those financial statements. The things that we're going to focus on this week-- and we'll do separate videos for each of these-- are adjustments to working capital that create cash flows or cash drains on the firm. Depreciation and capital expenditures. Those are sometimes cash and sometimes non-cash expenditures. And we'll work through each of those. And then we'll talk about asset sales, salvage values, or terminal values that happen sometimes when I sell stuff or wind up a project at the end. I'll want to make sure I'm recording every dollar of cash when I sweep clean the project when it's over. And then we'll talk a little bit about taxes, which are real cash flow as well. Our measure of free cash flow-- here it comes. Were going to start with operating profit. It's a good place to start. Did you make money or lose money? Operating profit after tax, our measure that came from the income statement. Good place to start. We're going to subtract out any increases in working capital. We're going to add back depreciation expenses, since that's a non-cash expense that money never really left us, so we're going to add that back. We're going to subtract out capital expenditures. That's money that we spent on new assets, but didn't get recorded up in operating profits. We're going to add back after tax salvage value. That's money for stuff that we sold, but that didn't get recorded up in operating profit. We're going to go back and get that back into the statement of free cash flows. To sum up, all those capital budgeting metrics that we talked about, net present value, internal rate of return-- those are all based on real cash. Free cash flow is what's going to drive valuation within the firm. Cash creation, not earnings, are what's going to drive valuation. So measuring free cash flow is paramount, and that's what we're going to spend the rest of this week doing, going through each of those adjustments in the formula for computing free cash flow.
