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Every day we bring you a new technical question, see below for today’s.
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Question
Why Net Income is not Free Cash Flow
Answer
At first thought, you might think that we could use this Net Income of $172mm as our basis for the amount of cash the business generated in this year. But, let’s also think about how we got there. For example, Depreciation and Amortization don’t affect our cash balance, so that already proves Net Income does not equal cash profit.
Let’s also say that the business purchased three more factories this year for $150mm in cash, this isn’t being accounted for on the Income Statement anywhere. Certainly that would impact cash.
Let’s also say that the business purchased $20mm of Inventory. Surely this would affect our cash balance.
The nice thing about all of the instances we just mentioned above, is that they’re all accounted for in Free Cash Flow! See below for the formula:
Free Cash Flow = Net Income + D&A - Change in Working Capital - Capital Expenditures
D&A is obviously the same $40mm we mentioned above, let’s just say the all Working Capital changes canceled themselves out aside from the increase of $20mm in Inventory and the $150mm of the three new factories falls under Capital Expenditures.
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