Discussion concerning the use and calculations is a popular topic within the investment community. While a company’s earnings gets a majority of the attention, cash flow has gained a certain amount of recognition – for good reason. Analyzing a company’s free cash flow can provide a solid insight into true profitability.

The process of calculating free cash flow is relatively straightforward. Most define it as the following (assuming the direct method);

Net Income
+ Non cash charges (depreciation/amortization)
+/- Changes in working capital
- Capital expenditures (some prefer to use maintenance cap exp)
= Free Cash Flow.

Although it is a simplified formula, this definition works well in most cases. We should always attempt to dig deeper into these numbers where appropriate. In my experience of analyzing company’s cash flows, there is a type of company where I feel this formula falls short. It’s with the serial acquirer. I’m not talking about those large deals that grab the headlines such as Intel, HP, or IBM. I’m talking about companies that consistently make small acquisitions annually as part of their business plan. They usually occur when a good size company dominates a niche market that is highly fragmented. With this in mind, let’s begin with our first example;

VCA Antech (WOOF)

2009	2008	2007	2006	2005
Period End Date	12/31/2009	12/31/2008	12/31/2007	12/31/2006	12/31/2005
Period Length	12 Months	12 Months	12 Months	12 Months	12 Months
Stmt Source	10-K	10-K	10-K	10-K	10-K
Stmt Source Date	02/26/2010	02/26/2010	02/26/2010	03/01/2007	03/14/2006
Stmt Update Type	Updated	Reclassified	Reclassified	Updated	Updated
Net Income/Starting Line	135.59	137.11	124.86	105.53	67.82
Depreciation/Depletion	39.57	31.91	27.05	22.24	19.34
Amortization	0.0	0.0	0.0	0.0	0.0
Deferred Taxes	24.6	22.58	10.94	7.69	10.5
Non-Cash Items	18.23	11.28	3.25	1.36	24.84
Changes in Working Capital	-34.52	-5.58	7.66	-9.93	-7.4
Cash from Operating Activities	183.47	197.31	173.76	126.89	115.1
Capital Expenditures	-50.8	-55.05	-48.71	-35.32	-29.21
Other Investing Cash Flow Items, Total	-79.97	-157.67	-222.59	-52.42	-86.22
Cash from Investing Activities	-130.77	-212.71	-271.31	-87.73	-115.43

There is nothing inherently wrong with making these ‘tuck-in’ acquisitions as long as they profitably contribute to the long term growth plan. However, they must be accounted for in the free cash flow calculation – at least in my opinion. These acquisitions represent an ongoing capital expenditure – similar to a retailer spending cap exp to expand its footprint. The company’s acquisition history is clearly laid out in the 10K filing. However, if you want to take the quick and dirty approach simply subtract out “other investing cash flow items” from the standard free cash number. While it isn’t perfect it will give you a much better (and more conservative) indicator of real cash being spent on the business.

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