Adjusted average free cash flow: Meaning, Criticisms & Real-World Uses

What Is Adjusted Average Free Cash Flow?

Adjusted Average Free Cash Flow refers to a refined measure of a company's financial performance, representing the average amount of cash a business generates from its operations after accounting for capital expenditures and making various user-defined adjustments to the standard Free Cash Flow (FCF) calculation over a specific period. It belongs to the broader category of financial analysis and valuation metrics, providing a more normalized and often more insightful view of a company's ability to generate surplus cash. Unlike a single period's FCF, the "average" component helps smooth out fluctuations due to irregular capital outlays or one-time events, offering a more stable metric for assessing a company's true financial health and capacity for growth, debt reduction, or shareholder distributions. Analysts and investors often adjust FCF to remove non-recurring items or to standardize comparisons across different companies or time periods, thereby enhancing its utility beyond the basic calculation derived from financial statements.

History and Origin

The concept of Free Cash Flow (FCF), upon which Adjusted Average Free Cash Flow is based, gained prominence in financial discourse as a valuable metric for evaluating corporate performance and intrinsic value. While the idea of cash flow available after necessary investments has long been implicit in corporate finance, the term "free cash flow" was notably popularized by Michael C. Jensen in his 1986 paper on the agency costs of free cash flow. Jensen defined it as "cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital."⁶

His work highlighted the potential for management and shareholder conflicts over the use of such surplus cash. Over time, practitioners and academics began to recognize that a single period's FCF could be volatile due to the timing of large capital expenditures or significant changes in working capital. This led to the practice of averaging FCF over several periods to present a more stable and representative picture. Furthermore, as companies increasingly presented non-GAAP (Generally Accepted Accounting Principles) financial measures, the need for "adjusted" FCF arose to exclude items that might distort a company's underlying operational cash generation, such as non-recurring gains or losses. The U.S. Securities and Exchange Commission (SEC) has provided guidance on the presentation and reconciliation of non-GAAP measures like free cash flow, emphasizing the need for clear descriptions of how they are calculated and reconciled to comparable GAAP measures.⁵

Key Takeaways

Adjusted Average Free Cash Flow provides a smoothed and normalized view of a company's cash-generating ability over multiple periods.
It is a non-GAAP measure, meaning its calculation can vary and requires clear disclosure of adjustments made to standard Free Cash Flow.
The metric helps analysts and investors assess a company's capacity for reinvestment, debt repayment, and shareholder returns, free from short-term distortions.
A positive and consistent Adjusted Average Free Cash Flow generally indicates robust operational efficiency and strong financial flexibility.
Understanding the specific adjustments made is crucial for proper interpretation, as different adjustments can lead to varying conclusions about a company's financial health.

Formula and Calculation

The calculation of Adjusted Average Free Cash Flow begins with the standard Free Cash Flow (FCF) formula, often starting from cash flow from operating activities, and then applies specific adjustments before averaging over a chosen period (e.g., three or five years).

The basic FCF formula is:

\text{Free Cash Flow (FCF)} = \text{Cash Flow from Operating Activities} - \text{Capital Expenditures}

Alternatively, FCF can be derived from the income statement and balance sheet:

\text{FCF} = \text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation & Amortization} - \Delta \text{Working Capital} - \text{Capital Expenditures}

Where:

(\text{EBIT}) = Earnings Before Interest and Taxes
(\text{Tax Rate}) = Company's effective tax rate
(\text{Depreciation & Amortization}) = Non-cash expenses for asset usage
(\Delta \text{Working Capital}) = Change in non-cash current assets minus change in non-interest-bearing current liabilities
(\text{Capital Expenditures}) = Investments in property, plant, and equipment

To calculate Adjusted Average Free Cash Flow, one would:

Calculate the FCF for each period (e.g., year 1, year 2, year 3).
Apply specific, clearly defined adjustments to each period's FCF. Common adjustments might include:
- Excluding non-recurring income or expenses (e.g., proceeds from asset sales, one-time legal settlements).
- Normalizing working capital changes if they are unusually high or low in a given year.
- Adjusting for specific, non-operational cash flows that distort the underlying business performance.
Sum the adjusted FCFs for the chosen periods.
Divide the sum by the number of periods to get the average.

\text{Adjusted Average FCF} = \frac{\sum_{i=1}^{n} (\text{FCF}_i \pm \text{Adjustments}_i)}{n}

Where:

(\text{FCF}_i) = Free Cash Flow for period (i)
(\text{Adjustments}_i) = Specific adjustments made in period (i)
(n) = Number of periods averaged

The adjustments should be consistently applied and clearly disclosed to maintain transparency and comparability.

Interpreting the Adjusted Average Free Cash Flow

Interpreting Adjusted Average Free Cash Flow involves more than just looking at a positive or negative number; it requires context about the company's industry, business cycle, and strategic initiatives. A consistently positive and growing Adjusted Average Free Cash Flow generally indicates that a company is generating sufficient cash from its core operations to cover its investments in maintaining and growing its asset base, with surplus cash available. This surplus can be used for various purposes, such as paying down debt financing, repurchasing shares, distributing dividends to shareholders, or funding future expansion without relying heavily on external equity financing.

Conversely, a consistently negative or declining Adjusted Average Free Cash Flow may signal potential issues. While negative FCF can be acceptable for high-growth companies heavily investing in future expansion, a sustained negative trend without clear growth drivers could indicate operational inefficiencies, excessive capital spending relative to cash generation, or underlying profitability challenges. It is essential to analyze the components of the adjustments made, as well as the underlying cash flow from operating activities and capital expenditures, to understand the drivers behind the adjusted average. Comparing a company's Adjusted Average Free Cash Flow to its historical performance and to industry peers can provide valuable insights into its financial strength and sustainability.

Hypothetical Example

Consider "Tech Innovations Inc.," a software company, and its Free Cash Flow over three years, along with some specific adjustments:

Year 1:

Cash Flow from Operating Activities: $120 million
Capital Expenditures: $30 million
One-time gain from sale of non-core asset: $10 million (non-recurring, user-defined adjustment to exclude)
FCF Year 1 (unadjusted): $120 - $30 = $90 million
Adjusted FCF Year 1: $90 million - $10 million = $80 million

Year 2:

Cash Flow from Operating Activities: $150 million
Capital Expenditures: $40 million
No significant adjustments for this year.
FCF Year 2 (unadjusted): $150 - $40 = $110 million
Adjusted FCF Year 2: $110 million

Year 3:

Cash Flow from Operating Activities: $180 million
Capital Expenditures: $60 million
One-time legal settlement expense: $15 million (non-recurring, user-defined adjustment to add back)
FCF Year 3 (unadjusted): $180 - $60 = $120 million
Adjusted FCF Year 3: $120 million + $15 million = $135 million

To calculate the Adjusted Average Free Cash Flow for Tech Innovations Inc. over these three years:

\text{Adjusted Average FCF} = \frac{(\$80 \text{ million} + \$110 \text{ million} + \$135 \text{ million})}{3}

\text{Adjusted Average FCF} = \frac{\$325 \text{ million}}{3}

\text{Adjusted Average FCF} \approx \$108.33 \text{ million}

This Adjusted Average Free Cash Flow of approximately $108.33 million provides a more stable representation of Tech Innovations Inc.'s cash generation capacity over the period, stripping out the volatility caused by specific non-recurring events. This figure is more useful for long-term investment decisions and forecasting than any single year's unadjusted FCF.

Practical Applications

Adjusted Average Free Cash Flow serves as a crucial metric across various domains of finance and investment analysis due to its smoothed and refined perspective on a company's cash generation.

Corporate Valuation: In discounted cash flow (DCF) models, future free cash flows are projected and discounted back to the present to estimate a company's intrinsic value. Using an Adjusted Average Free Cash Flow as a basis for forecasting can lead to more reliable and less volatile projections, providing a more stable input for valuation models.
Credit Analysis: Lenders and credit rating agencies use Adjusted Average Free Cash Flow to assess a company's ability to service its debt obligations. A consistent, strong adjusted average indicates ample cash reserves for timely interest payments and principal repayments, reducing credit risk.
Capital Allocation Decisions: For management, the Adjusted Average Free Cash Flow helps inform decisions regarding reinvestment in the business, share buybacks, dividend payments, or mergers and acquisitions. It provides a clearer picture of internally generated funds available for discretionary uses beyond maintaining current operations.
Comparative Analysis: By normalizing FCF over time and adjusting for unique events, the metric facilitates more accurate comparisons between companies, especially those in capital-intensive industries or those undergoing periods of significant investment or divestment. This enhanced comparability supports more informed investment decisions.
Understanding Profitability and Liquidity: While net income reflects accounting profit, Adjusted Average Free Cash Flow provides a more tangible measure of actual cash available, offering a clearer picture of a company's true liquidity and its capacity to fund operations and growth without external financing.⁴

Limitations and Criticisms

Despite its utility, Adjusted Average Free Cash Flow has several limitations and faces criticisms that users must consider for a balanced view.

One primary criticism stems from its nature as a non-GAAP measure. Since there is no standardized definition or regulatory mandate for calculating "adjusted" FCF, companies have discretion over what adjustments they make. This lack of uniformity can lead to inconsistencies between companies, making direct comparisons challenging unless the adjustments are meticulously understood and re-calculated. The U.S. Securities and Exchange Commission (SEC) has issued guidance emphasizing that companies must clearly describe how free cash flow is calculated, especially when it deviates from common interpretations, and must not present it in a way that implies it represents residual cash flow available for all discretionary expenditures if mandatory obligations are not deducted.³

Furthermore, even with averaging, Adjusted Average Free Cash Flow can still be influenced by significant, lumpy expenditures or revenues, particularly for companies in industries with high capital expenditures or cyclical operations. For example, a company investing heavily in a new facility might show lower FCF for several years, even if this investment promises strong future returns.² Misinterpreting a negative adjusted average FCF in such a growth phase could lead to an inaccurate assessment of a company's potential.

The adjustments themselves can be subjective. Deciding which items are truly "non-recurring" or "non-operational" can vary among analysts or management, potentially allowing for manipulation to present a more favorable cash flow picture. Analysts must delve into the footnotes of financial statements to understand the nature of adjustments and assess their reasonableness. Finally, Adjusted Average Free Cash Flow, like FCF, focuses on historical performance. While useful for trend analysis, it does not inherently predict future cash flows or account for potential shifts in market conditions, competitive landscapes, or operational strategies that could impact a company's ability to generate cash going forward.¹

Adjusted Average Free Cash Flow vs. Free Cash Flow

The primary distinction between Adjusted Average Free Cash Flow and standard Free Cash Flow (FCF) lies in two key aspects: adjustments and averaging.

Feature	Free Cash Flow (FCF)	Adjusted Average Free Cash Flow
Calculation Basis	Cash from operations minus capital expenditures.	Starts with FCF, then applies specific user-defined adjustments.
Time Horizon	Typically calculated for a single reporting period (e.g., one quarter or one year).	Calculated over multiple periods (e.g., 3-5 years) and then averaged.
Purpose	Provides a snapshot of cash generated from core operations for a specific period.	Offers a smoothed, normalized, and refined view of sustainable cash generation, removing short-term distortions.
Volatility	Can be highly volatile due to timing of large investments or one-time events.	Aims to reduce volatility by averaging and removing non-recurring items.
Comparability	Less comparable across periods or between companies if significant one-time events or irregular capital cycles occur.	More comparable across periods and potentially between companies once adjustments are clearly understood and consistently applied.
Decision Utility	Useful for short-term liquidity assessment.	More suitable for long-term valuation, strategic planning, and assessing consistent financial health.

While standard FCF gives an immediate picture of a company's cash position after essential investments, Adjusted Average Free Cash Flow aims to present a more stable and representative measure of its ongoing cash-generating power by filtering out anomalies and normalizing the data over time. The confusion often arises because both metrics measure cash flow after capital investments, but the "adjusted" and "average" components of the latter are critical for understanding its distinct analytical value.

FAQs

Why is Free Cash Flow "adjusted" and "averaged"?

Free Cash Flow is "adjusted" to remove the impact of one-time events or non-recurring items that distort a company's underlying operational cash generation. For example, a large, infrequent asset sale or a one-time legal payout could significantly inflate or depress FCF for a single period, not reflecting the normal course of business. It is "averaged" over multiple periods to smooth out the inherent volatility of capital expenditures. Companies don't always invest the same amount in property, plant, and equipment every year; these can be lumpy outlays. Averaging helps to normalize this, providing a more stable and representative measure of consistent cash flow.

Is Adjusted Average Free Cash Flow a GAAP measure?

No, Adjusted Average Free Cash Flow is a non-GAAP (Generally Accepted Accounting Principles) measure. This means there are no standardized rules or regulations mandating its calculation or presentation. Companies and analysts create and define their own adjustments, which highlights the importance of always looking at the reconciliation to a GAAP measure, such as cash flow from operating activities, and understanding the specific adjustments made.

How many years are typically used for the "average" calculation?

The number of years used for the "average" calculation can vary, but typically, analysts look at a period of three to five years. This timeframe is often considered long enough to smooth out short-term fluctuations and irregular capital expenditures but not so long that it includes outdated financial data that might not reflect the company's current business model or economic environment.

What are some common adjustments made to Free Cash Flow?

Common adjustments made to Free Cash Flow can include adding back or subtracting non-recurring items (such as one-time gains or losses from asset sales, legal settlements, or restructuring charges), accounting for deferred revenue or expenses that significantly impact reported cash flow in a single period, or normalizing working capital changes if they are unusually volatile. The goal is to isolate the cash flow generated from the company's core, ongoing operations.

Why is this metric important for investors?

Adjusted Average Free Cash Flow is important for investors because it offers a clearer, more stable picture of a company's true capacity to generate cash. This cash is what allows a company to repay debt, pay dividends, repurchase shares, or reinvest in its own growth without needing to raise additional equity financing or debt financing. A strong and consistent Adjusted Average Free Cash Flow indicates a financially healthy business with robust operational performance and significant financial flexibility.