JAMES P. WESTON: Hi, welcome back to finance for non-finance professionals.

This week, we're talking about cash flow and measuring cash creation

through the financial statements.

Now that we've kind of moved through, in all the previous lessons,

all the ingredients that go into computing free cash flow, what we're

going to do in this lesson is work through a real example

and cook with those ingredients that come up

with a measure of cash flow in a simple example.

So again, our free cash flow measure is we

start with operating profit, which is a good place to start.

After-tax operating profit.

How much cash is being generated on the income statement.

Subtract off any increase in working capital because that's

a cash drain on the firm.

Add back the depreciation expense because that never really left.

Subtract off capital expenditures-- money

that we spent that we didn't record up in the income statement.

And add back any after-tax salvage value or asset sales

that reflect real cash coming in that we didn't report up

in the income statement.

So let's walk through a really simple example together

and hopefully get a better sense of how to compute free cash flow.

Let's take a look at what's going on in this real simple example.

In year zero, when I start this project, what am I doing down here?

I've got some capital spending of $500.

So I'm going to spend, let's say $500.

And then I'm not going to do any spending

in any of the next three years.

So this is really sort of an upfront expense of $500.

That gives me net property, plant, and equipment of $500 at the beginning.

No cash from operations in the first year.

Working capital and investment in working capital of $150 in year zero.

OK.

Then what happens?

I'm going to start generating.

By the end of year one, I'm going to have recorded some cash

flow on the income statement.

So $500 in years one, two, and three.

OK.

That's the sales coming in, revenue.

To generate those revenues it took total cost of $300.

And I've got a depreciation expense of $100 each period.

That should be reflected in the decline in net property, plant, and equipment

of $100.

And sure enough, $500 goes down to $400, $400 to $300, $300 to $200.

OK.

That's the decline in the value of property, plant, and equipment

by $100 depreciation expense.

That $100 depreciation expense is what drives the value of the asset down.

OK.

Then that gives me earnings before interest and taxes of $500,

minus $300 is $200, minus the $100 depreciation expense

gives me EBIT of $100.

At a 30% tax rate, I tax that EBIT at 30%.

That gives me a tax of $30.

$100 minus the $30 in taxes gives me $70-- or $700,000,

$70,000-- in net operating profit after tax.

Net operating profit after tax or NOPAT.

And that's the same each year.

$500 minus $300, minus the depreciation, gives me $100 each year.

Minus the taxes, gives me NOPAT of $70.

OK.

So net operating profit after tax of $70 each year.

Now we've got all of our ingredients to cook here.

What happened to working capital?

Working capital went from $150 down to $100.

So maybe that was inventory in the warehouse.

Maybe I invested in $150,000 worth of product in the warehouse.

I worked down the inventory to $100.

Work it down again to $50.

Work it down again to $0.

So a change in working capital of $50.

A change in working capital of $50.

And a change in working capital of $50.

So three changes in working capital.

Now I've got everything I need to compute free cash flow.

Let's see what happened.

Have I got any cash from operations?

Any net operating profit after tax?

I've got nothing here.

I've got no depreciation.

What have I got?

I've just got some capital spending of $500,

and I've got my initial investment, my initial increase

in working capital of $150.

That's what it took, an investment in working capital,

to get the project off the ground.

That gives me a total spend of $500 and $150,

for a total free cash flow of minus $650.

That's the initial investment.

That's how much it took me to get this project off the ground.

Now that we're generating some revenue there's

going to be some cash coming in.

In year one, I've got net operating profit after tax of $70.

Now, that's $70, but that $100 in depreciation never left.

I'm going to add it back.

That gives me cash from operations of $170, NOPAT plus depreciation.

What else happened here?

I've got no capital spending.

So I've got $170 cash from operations and I've got a decrease

in working capital of $50.

Now remember, this double change always gets confusing.

I was going to subtract off any increase in working capital.

So if I subtract a decrease in working capital, subtracting a negative

is adding.

So really the decrease in working capital

is money that's been freed up by moving, say, inventory out of the warehouse

and into sales.

That's freed up $50 in cash flow. $170 plus $50 gives me $220.

So again, net operating profit after tax of $70.

Add back $100 in depreciation.

Subtract off no capital expenditures.

Add back a minus $50 in capital expenditures gives me--

and I didn't sell anything, sell any assets--

so that gives me a total free cash flow of $220.

The next year is going to be the same.

NOPAT of $70.

Subtract the negative decrease of working capital, means add $50.

Add back depreciation.

No capital expenditures to add back.

No asset sales.

Gives me total free cash flow of $220.

In the last year, things are going to be a little bit different

because what have I got at the end?

I've got NOPAT of $70, add back the $50 decrease in working capital,

add back the $100 in depreciation.

No capital expenditures to subtract off, but I've got a terminal value.

I've got asset sales.

I'm going to record the fact that I've got a net property, plant,

and equipment.

I've got an asset that's worth $200.

I need to add that back as my terminal value.

I need to pretend as though I'm going to sell it for it's book value. $200.

OK.

So I add that back to-- that's $220, plus the $200 in asset sales,

gives me free cash flow of $420.

So net profit after tax, add back any change in working capital,

subtract capital expenditures, add back depreciation, add back the cash

from anything that I sold, gives me my measure of free cash flow each period.

Minus $650, $220, $220, $420.

And that's it.

That's Walking through a real simple example of constructing free cash

flow from the information we get from the balance sheet, income

statement, and statement of cash flows.