i’m very very new at this. hope u can help out.

i do not have any strong educational background on finance or accounting, so most of the time i get confused with some of the financial formulas. So, i hope u would understand how little knowledge i have, but i’m still learning

i have just finished reading “Fundamental Analysis for Dummies”, but the book doesn’t provide FCF formula.

only today i found out about “Owners Earnings” aka FCF, and because Warren Buffet is using it, i would too.

i’m currently making a personal excel spreadsheet. My purpose is because i want to have a deeper understanding of its formulas, its explanation, how to extract information from financial reports.

i want to start from the bottom/basic.

Now, back to my question and Its about capital expenditure.

1. Is it previous year (TA-TL) minus current year (TA-TL)or the other way around.

2. is it suppose to be just a positive number? because, if its negative and i put it in the Owner earnings formula it would become positive.

i tried to google it, but it seems that most of the people in most forums are quite advanced. so, its not discuss whether its supposed to be +ve or -ve.

Similiarly the overall FCF (net sum from all three sections) number is just not that useful, I completely agree with you.
Why? Just check your bank account on online banking, put the individual entries into excel for the last few months. These numbers we all know in and out. You know if you were frugal and saved every penny, or if you spent money on everything thats nice and shiny.
So what does the overall change in your cash account from your personal balance show… inflow =x,000, outflow = x,000? so what does that tell me on how much im spending? nothing. It suddenly does start to make sense when the individual accounts are categorized (transport costs, rent costs etc etc)and the long-term or one-off things are excluded. That’s close to the income statement though. So income statement is roughly fine except for a few points, certainly better then FCF I+FCF O+FCF F. if the sum of everything does not even give a clear picture for an individual person, it certainly won’t for a large corporation.

However..
!!! Why would you include all the Capex… Warren Buffett means maintenance capex! That’s a number one has to find out for oneself..but that’s good! You will agree, those sort of things are the whole fun of analyzing.. going beyong capital iq and bloomberg : )

If you earned 40 k last year after deducting all expenses. you also bought a house for 200k that year too… you cant say I made -160 k last year you see.
The capex is an investment (might be a lousy one, so have unforeseeable investment risk like an investment in an investment, so many investors dont like huge growth capex, instead prefer (ideally) something close to a safe cashcow at a discount for whatever reason).
It has a salvage value… it is expected to create future cash flows..
so it does not belong in THIS period and it is not an expense. Take it out!
doing what you do, doesn’t kill, it will simply automatically select only companies with minimal capex requirements. I would rather do a seperate analysis on this.

Some companies are very stable yet growth capex intensive. if a company builds great trucks with a great growing customer basis, and builds a new plant, dont see a problem with that. So I prefer to know how much was invested, and how? is it a safe investment?

Now lets look at another capex. Say lets say someone has a house and rents it out.
if he spends money (equity or debt) to repair something, install some energy meter… that doesn’t create value, it won’t increase the value of the house through future rents. It only maintains the house and keeps the tennants happy. So it’s maintenance capex, and an expense indeed.

In contrast, if one expands the house on the roof with nice balconies and 3 extra appartments… that’s essentially like buying an extra house. It’s growth capex, and not a pure expense, so I wouldn’t deduct it from earnings. Growth capex will probably also be financed mostly through debt and not through money which the business earns in that period.. hence income will be continuous and expenses also (interest+principal). deducting the whole thing from one period seems “unfair” to the company . Afterall, you didn’t include the financing they took (usually loan or bond) for realizing the project. Let’s also not forget the company tries to estimate capex numbers generous, so they can depreciate as much as possible.

Maintenance capex will probably in most cases be paid off with money generated quite recently. Some companies might even capitalize things which are not really capex, to improve net profit, an accounting trick. Wiki: “Capital expenditures (CAPEX or capex) are expenditures creating future benefits” so we’re looking for “unreal” capex, which we as shareholders would rather regard as simply an extra cost to add to the income account.

Receivables Current Period: $120
Receivables Previous Period: $100
Inventory CP: $75
Inventory PP: $75
Prepaid CP: $10
Prepaid PP: $10
Current Liabilities: $50
Previous Liabilities: $50

The result is an increase in working capital, which Heiserman and others consider a use of capital, of $20. Therefore, we’d make an expense for that amount to signify we used an additional $20 of capital over last period. This is not entirely correct. We did ship products valued at that amount to our customer and awaiting payment but we didn’t necessarily poor additional capital into the receivables chain in the same regard if the increase would have taken place in inventories. But, there is an opportunity cost of capital in regards to those receivables that we are awaiting payment on. Further research on that subject matter is in process. If the above scenario ($20) was in regards to inventories, I think there’s no question that an accounting of that item should be included in overall capital expenditures. But the more important thing to take notice of, in my opinion, isn’t so much whether working capital has increased or not, but the balance or imbalance of receivables and inventories which is far more important than possibly squeezing a few more pennies per share of EPS.

Capital Expenditures consist of PPE. E doesn’t equal inventories and receivables. Maintenance CapEX, which is apart of the overall CapEX, doesn’t include receivables and inventories either. Receivables and Inventories are a necessary expenditure that require the use of cash and should be accounted for if you’re sure that, in regards to inventories, the units have increased rather than just the LIFO value which can fluctuate the book value of unchanged units of inventory.

This is what I believe Buffett was saying. The way he worded, however, made it difficult to comprehend without some serious thought of the matter and you never know, my ideas could be complete hog wash as well.

As you state, I may not know basic accounting but if you read the context and not just the sentence you would have realized I was talking about how WC affects cashflow.

If you give me a loan of $1,000,000 for 1 year, you’re out of that money from your pocket. From a cash flow point of view, how is that assets?

Balance sheet, yes, but cash flow, no.

I do agree with your reason for not include WC which I also included.
“Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.”

I thinking there is more pratical reason why change in working capital should not be adjusted in FCF formula. Of all the FCF items, WC Is most volatile and unpredictable item as per my experience. WC changes have far greater impact on FCF than any other item and often these changes are only temporary. In order to arrive at a more predictable FCF it is better to calculate FCF without WC changes.

I guess this is another part of the art involved in valuation. Both you guys have valid points and I don’t believe there is a right or wrong.

But at least now that I have my side of the argument down in writing, people will see why I don’t include it in the spreadsheets.

Rather or not the calculation of FCF is to determine how much a business generates in cash or simply the profitability of the business, I am not really sure. I think it is both. I did and I continue to regularly read the 1986 letter to shareholders which adds to my confusion. He has said countless times that the value of a company is how much cash a business can generate. If the company increases it sales, but of instead of increasing the cash position, the a/rs increase, the company has not yet generated more cash because there is still the possibility that it may not collect on the receivables. My thinking is to be conservative and to wait until cash is actually received and thus deduct a/r and etc.

But I can see the argument for both sides and I am probably off base here.

Although I agree that using cash to increase inventory, and other assets is a real business expense, I see it nothing more than measuring the short term liquidity of a business. It doesn’t add any affects to profitability and earnings power of the business at all.

If the balance sheet revealed increases in inventories and accounts receivables, it is a major warning sign right away and I probably wouldn’t even work my way down to the FCF line.
So while I understand why people want to include changes in working capital, I don’t believe it serves the purpose of providing a proper view of the business profitability. I mean, just by seeing the trend of receivables and payables and doing an analysis of inventory will reveal most things.

@ slinj,
Yup just doing the routine cash flow statement analysis and looking at receivables, payables, inventory and other liabilities should help even more.

I don’t really follow your explanation of accounts receivable…If they increase, it means working capital increases which is a drain on your cash…and hence gets deducted from free cash flow in “classic” FCF calculations. Your post seems to indicate otherwise.

Hence if a business is increasing payables and/or inventory due to growth or market competition or whatever, it should be discounted from cash flow as it is a business expense that you ‘have to incur’ (assuming management is doing its best). Thus even as a business owner and not ‘just’ a stockholer this use of cash is very real and impacts the cash that is left for owners after running normal business expenses.

This usually does not make a large difference for most stable businesses and hence – if you take a good margin of safety – should not change your view on investing in a business. But it may be a good thing to track for businesses that are growing fast as well as those in a downturn which need to keep increasing payables/inventories.

Cheers,
Ben