Fixed Capital and Working Capital

You may feel overwhelmed by the formulas in this topic review. We’ll show you the ones you need to know for this LOS without showing you the derivations. The basic idea is that we can arrive at FCFF by starting with one of four different financial statement items (net income, EBIT, EBITDA, or cash flow from operations [CFO]) and then making the appropriate adjustments.

Then we can calculate FCFE from FCFF or by starting with net income or CFO.

Calculating FCFF from net income. FCFF is calculated from net income as:

Notice that net income does not represent free cash flows defined as FCFF, so we have to make four important adjustments to net income to get to FCFF: noncash charges, fixed capital investment, working capital investment, and interest expense.

Noncash charges. Noncash charges are added back to net income to arrive at FCFF because they represent expenses that reduced reported net income but didn’t actually result in an outflow of cash. The most significant noncash charge is usually depreciation.

Here are some other examples of noncash charges that often appear on the cash flow statement:

• Amortization of intangibles should be added back to net income, much like depreciation.
• Provisions for restructuring charges and other noncash losses should be added back to net income. However, if the firm is accruing these costs to cover future cash outflows, then the forecast of future free cash flow should be reduced accordingly. Gains or losses on sale of long term assets are also removed (they would be accounted for under fixed capital investment).
• Income from restructuring charge reversals and other noncash gains should be subtracted from net income.
• For a bond issuer, the amortization of a bond discount should be added back to net income, and the accretion of the bond premium should be subtracted from net income to calculate FCFF.
• Deferred taxes, which result from differences in the timing of reporting income and expenses for accounting versus tax purposes, must be carefully analyzed. Over time, differences between book and taxable income should offset each other and have no significant effect on overall cash flows. If, however, the analyst expects deferred tax liabilities to continue to increase (i.e., not reverse), increases in deferred tax liabilities should be added back to net income.
• Increases in deferred tax assets that are not expected to reverse should be subtracted from net income.
• Gains (losses) on sales of fixed assets are subtracted (added) because they are nonoperating and are included in the calculation of net fixed capital investment.

Fixed capital investment. Investments in fixed capital do not appear on the income statement, but they do represent cash leaving the firm. That means we have to subtract them from net income to estimate FCFF.

Fixed capital investment is a net amount: it is equal to the difference between capital expenditures (investments in long term fixed assets) and the proceeds from the sale of long term assets:

FCInv = capital expenditures − proceeds from sales of long term assets Both capital expenditures and proceeds from long term asset sales (if any) are likely to be reported on the firm’s statement of cash flows, as cash flow from investing activities (CAPEX acquired via a non cash exchange would be reported in the footnotes). If no long term assets were sold during the year, then capital expenditures will also equal the change in the gross PP&E account from the balance sheet. However, gross PP&E is often not provided; in that case we can use the formula based on net PP&E (shown in the following).

If no long term assets were sold during the year:

If long term assets were sold during the year, then:

• Determine capital expenditures from either (1) an item in the statement of cash flows called something like “purchase of fixed assets” or “purchases of PP&E” under cash flow from investing activities, or (2) data provided in the vignette.
• Determine proceeds from sales of fixed assets from either (1) an item in the statement of cash flows called something like “proceeds from disposal of fixed assets,” or (2) data provided in the vignette.
• Calculate FCInv = capital expenditures − proceeds from sale of long term assets.
• If capital expenditures or sales proceeds are not given directly, find gain (loss) on asset sales from the income statement and PP&E figures from balance sheet. Calculate FCInv = ending net PP&E − beginning net PP&E + depreciation − gain on sale. If there is a loss on sale of assets, add that instead of deducting it.