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John Emerson
John Emerson
Articles (106) 

Understanding Free Cash Flow Series: Depreciation and Accounts Receivable

June 27, 2011 | About:

"The ultimate value of a company is its ability to produce free cash flow." — Bob Olstein

If Warren Buffett was playing the role of Ned Pepper when he heard the aforementioned quote he might proclaim: "I call that bold talk for a one-eyed fat man." Read on in the article to find out why; how is that for a tease?

Most serious investors take accrual earnings with a grain of salt; they prefer to measure the profitability of a company by its free cash flow or in some cases its owner/earnings, as described by Warren Buffett. The subject of today's article is a discussion of free cash flow (FCF) in regard to depreciation and accounts receivable, with the aim of educating the investors about its strengths and weaknesses.

Definition of Free Cash Flow (FCF)

For the purposes of this article, I am going to define FCF as: cash flows from operations minus capital expenditures. This information is easily attainable by accessing the 10K of any publicly-traded stock and studying the cash flow statement. MSN Money provides a five-year summary of this data in a condensed version, which makes the computation quick and simple. The information you need is listed near the top section of the Cash Flow Statement. Merely take Cash Flows From Operating Activities and subtract out Capital expenditures (listed on lines seven and eight of the cash flow statement.)

Note that GuruFocus also lists the total cash flows from operations on both a yearly and quarterly basis. To access the information, list the symbol of a company in the search box, then merely click on 10-Y Financials. GuruFocus compiles their own calculation of FCF and lists the tabulation at the bottom of the Cash Flow Statement.

What Is Cash Flow from Operations and Why Is It Important?

Generally speaking, cash flow from operations is the amount of cash a business generates before it makes any investing decisions. Investing decisions include such things as purchasing new plants and equipment, maintaining old equipment, acquiring new businesses or otherwise redeploying the capital.

Generating cash is important since it can be used to finance the operations of a business in lieu of adding debt or increasing paid-in capital (selling shares). Excess cash can be used to pay dividends, repurchase stock, pay down debt or expand business growth.

Accrual Earnings vs. Free Cash Flow

Accrual earnings represent the amount of income or losses that are depicted on the Income Statement of a company. Accrual earnings differ in two material ways from cash flow; specifically, accrual earnings factor in depreciation and amortization as costs while neglecting to detail changes in working capital.


Remember the teaser I provided at the beginning of the article where Warren Buffett fictionally calls out Bob Olstein on his quote about free cash flow being the ultimate value of a company? The foundation of Buffett's mythical objection is the concept that depreciation is an actual expense, a concept which free cash flow fails to recognize at regular intervals.

Extracting free cash flow from a business could be compared to extracting gold from a mine. Just as producing gold requires initial and ongoing capital expenditures, so does producing cash in virtually any business. The degree of capital expenditures required to mine cash varies greatly from business to business; therefore, it is impossible to assess the true profitability of future cash flows if one does not correctly factor in the true cost of depreciation.

Imagine that I own and operate a one-man trucking company. For the sake of round numbers say that I saved $100,000 which was sufficient to purchase a rig suitable for my hauling business. Let's further assume that the rig is good for 10 years, at which time I need to buy a new one or I can no longer conduct business. Thus, the cost of depreciation is $10,000 per year. Further, imagine that after all the other expenses are factored in, I am able to make $50,000 a year with my one-rig operation.

Let's assume that I purchased the rig in 2005 and I am now burned out from driving, so I decide to sell the business to another driver. In the interest of salesmanship, I decide to show him the cash flow statement of the business as well as the income statement. For the sake of argument let say that both statements are identical, with the exception of a $10,000 depreciation expense listed on the income statement.

Immediately the potential buyer is confused. He wants to know how much he can expect to make per year if he buys the business. I point to the cash flow statement and tell him that is the bottom line — the depreciation is just a tax write-off that I use to reduce the amount I pay Uncle Sam. To back up my point I produce cash flow statements from 2006 to the present which show that I have indeed produced $50,000 each year in cash. I selectively withhold the 2005 statement which shows that I burned $50,000 in cash flow the year that I purchased the rig.

Five years of proof is good enough for the naive buyer. We set the price based upon $50,000 per year rather than $40,000. In reality, the new buyer is setting on a nasty surprise in 2015 when he is going to have to fork out the price of a new rig, which will undoubtedly be considerably more expensive than the $100,000 I paid in 2005.

The above hypothetical example clearly demonstrates that depreciation is a real long-term cost of the business; however, the buyer overlooked that fact because he failed read the 2005 cash flow statement. The example depicts the peril that investors face if they do not factor in the underlying cost of depreciation on plant and equipment, which may or may not be listed on recent cash flow statements.

Walter Schloss would always examine the age and depreciation schedules of plant and equipment before he purchased a company. Understanding the age and anticipated life of P&E is instrumental in making an intelligent investment decision. Aging equipment can result in cash constraints in the near future. It may even signal an increase in impending debt or an upcoming secondary as potential replacement costs can lead to negative free cash flow.

On the other hand, companies with recently built plants and equipment with little depreciated value could represent a significant margin of safety in an investment, particularly if the companies' earnings are cyclical in nature and the current price per share is depressed.

Imperial Sugar (IPSU) is an example of a company that recently ended up with a new plant and equipment at their Port Wentworth facility due to an explosion and fire which destroyed their aging refinery. Insurance settlements paid for the new equipment, as well as provided a large lost income settlement, which was based upon a combination of factors, temporarily boosting earnings.

Changes in Working Capital

Changes in working capital represent such things as increases/decreases in accounts receivables, inventories, or accounts payable. Recognizing ongoing changes in working capital is essential in ascertaining the veracity of earnings as well as evaluating the efficiency of a business.

Accounts Receivable

Monitoring accounts receivable can expose companies that are embellishing their earnings, poorly managing their business or sometimes committing outright fraud.

A parable is in order: Let's assume that two highly dexterous brothers decide to form a handyman company, but they become divided upon a certain principle. Jake believes in the "Wimpy Principle" (a potential customer will gladly pay you Tuesday for a hamburger today), while Elwood follows the advice of his grandpa who owned and operated a bar for many years, specifically, "Do not extend credit."

The philosophical division negates any possible partnership, resulting in two separate businesses. Jake finds himself much busier than Elwood. Jake's business model is to avidly seek out retired widows whose houses are in various states of decay.

Jake does not lack for business – his problem is that many of his elderly clientele rely upon Social Security checks for their subsistence. Many of the widows are only able to make a partial payment but promise to make additional payments after the first of every month. Jake finds that most of the women are of good character and they pay a percentage of their bills on a steady basis. However, they generally request additional work on a monthly basis, and hence their balances never seem to dissipate. Instead, they tend to increase.

Elwood is not nearly as busy as Jake. In fact, he spends a good deal of time providing free estimates rather than conducting repairs. He curses under his breath whenever his rival, Dirt Cheap Enterprises, under-bids him. Then he complains to his brother Jake. Jake just laughs and says that Dirt Cheap does not bother him as they rarely bid against him. He tries to convince Elwood to change his motto of "cash on the barrel-head," but Elwood remains resolute.

Both Jake and Elwood hire the same accounting firm, "Pencil Pushers." Since they are brothers they frequently review each others' quarterly results. Jake crows like a rooster every time they compare income statements, as his revenues and profits are much higher than Elwood's. However, one thing continues to perplex him — he cannot figure out why every time he is required to send in his quarterly taxes, he has to borrow money. Elwood has no such problems.

After several years, Jake's problems are continuing to mount. By now he has leveraged his house and much to his chagrin, many of his elderly clientele are starting to miss payments for a variety of reasons. Several have died, and several others have now entered nursing homes. Jake falls behind on paying for his supplies and he ends up losing his credit. He can only procure supplies by paying cash. Still he is baffled.

According to his accountant, Jake is still making much more income than Elwood, although his brother has never been forced to borrow against his house. "How could this be happening?" he laments.

The answer is obvious — many of Jake's accounts receivable are no good and he has not recorded them as losses or created a reserve for bad debts. This example may be painfully obvious to readers, but for many investors who do not monitor cash flow statements or balance sheets, the parable is not so far-fetched. Consider the case of Home Solutions of America (HSOA), which was once recommended by Scott Black for the Barron's Roundtable.

Let's review the statement of cash flows for HSOA from the 2007 10K:

Consolidated Statements of Cash Flows

(Dollars in,000s)

For the Years Ended December 31
Cash Flows from Operating Activities200620052004
Net income$17,898$7,185$2,563
Depreciation and amortization1,6463,4031,102
Minority interest in income of consolidated subsidiary727933580
Provision for doubtful accounts2,82349544
Gain on sale of assets-177617
Stock-based compensation1,433952113
Gain on extinguishment of debt-129
Gain on sale of discontinued operations-3,177
Changes in assets and liabilities, net of acquisitions and divestitures:
Accounts receivable-15,883-13,710-989
Prepaid expenses and other current assets-2,425-490-382
Costs in excess of billings, net-5,177
Other assets-470-102135
Deferred taxes-544-2,475
Deferred tax liability890
Accounts payable and accrued expenses-9,504-852-344
Due to a related party-39524
Net cash provided by -used in operating activities-12,509-4,6762,734

In reality, the HSOA cash flow statement reflected a situation which was not so much different from Jake's dilemma. Although the company was recording outstanding net income, it was burning cash at an alarming rate. The main cash burn was a direct result of mounting accounts payable.

Of course, HSOA was later exposed as a fraud while Jake was merely a rube. However, any investor who paid attention to the statement of cash flows provided by HSOA would have been able to avoid a total loss of capital by selling their position long before the stock was delisted.


Paying attention the the cash flow statement of a business is an essential exercise if one wishes to be a successful investor. In most cases FCF is a much better metric of profitability than accrual earnings. However, completely ignoring the reality behind the numbers is just as perilous. Investors must remember that depreciation is a real expense and it must be factored into future earnings. Sometimes that fact is overlooked when an investor focuses too heavily on FCF.

The next edition of Understanding Free Cash Flow will deal with the concepts of amoritization, inventory, and maintenance vs. growth capital expenditures.

*I do not currently hold or intend to purchase shares in IPSU in the near future.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (38 votes)


Graemew - 6 years ago    Report SPAM
Hi John, thanks very much for this article. I was wondering how you deal with the problem that capital expenditures can be very irregular from year to year? For example in one year a company may buy a lot of new equipment and then the following year spend very little. (Do you normalise the capital expenditure? If so doesn't that work out similar to the concept of depreciation?)
Adib Motiwala
Adib Motiwala - 6 years ago    Report SPAM

excellent article. thanks for posting. exactly my thoughts. Typically companies have maintenance capex and growth capex. Very few break it out and report that ( example of one that does is ESV).

I was taking a look at PF Changs (PFCB) - a restaurant operator - Annual depreciation is $75 million, maintenance capex is $25 milliion and another $20 million is spent on opening new restaurants.

FCF adds back the depreciation as you rightly discussed but also considers the capex..... In the case of the Rig example you gave, i assume there was no maintenance capex. But, your point about looking at the life/age of the PPE is an excellent one.


John Emerson
John Emerson - 6 years ago    Report SPAM

First of all, remember I am generally an asset-player so when I make a purchase I typically make little or no attempt to predict future cash flows although if at all possible I want newer equipment. I want to purchase the plants at well under their replacement value, remember book value for fixed assets during deflation is likely overstated, and understated during inflation, so the best time to buy fixed assets is during inflationary periods. The best time to buy current assets is during deflationary times, net/nets are much better during a deflationary crisis, eg. 2008-2009.

Now to your question, yes I think averaging capex over ten years is a good idea but that might not be enough. P&E in certain industries have much longer depreciation schedules, clearly it pays to check accumulated depreciation, it gives one a good picture of exactly how old the assets are. It also prepares one for a potential nasty surprise.

The next article will discuss separating growth and maintance CAPEX, that is important is assessing the real cost of capital expenditures. Theoretically, growth capex is an investment not a cost (so long as it provides a significant ROI), but it still needs to be depreciated over the anticipated life of the asset. Maintainence CAPEX is all cost. If a company separates the two it makes things much easier if one wishes to predict long term FCF.

Thanks for intelligent response!
John Emerson
John Emerson - 6 years ago    Report SPAM
Thanks for the intelligent comment Adib,

It seems you beat me to the punch on maintanence vs growth capex, I will attempt to discuss the distinction in my next article. Separating the two is indeed important, I intend to use CASY as an example unless I change my mind in the interium.
Jhodges72 - 6 years ago    Report SPAM
I'll be interested in reading your article concerning Growth & Maintenance capex. Unless separately reported, I've never seen anyone successfully separate the two. The closest I've seen was Bruce Greenwald's description. Personally, I cyclically adjust all of it and deduct it. Good article.
Batbeer2 premium member - 6 years ago
- deleted -

Wrong thread.

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