Adjusted benchmark free cash flow

What Is Adjusted Benchmark Free Cash Flow?

Adjusted Benchmark Free Cash Flow is a customized financial metric used to evaluate a company's operational efficiency and financial performance by modifying its standard free cash flow (FCF) and then comparing it against a predetermined standard or peer group. This metric falls under the broader category of financial analysis and valuation, serving as a sophisticated tool for assessing a company's ability to generate cash that is truly available for distribution to investors or for strategic reinvestment after all necessary expenditures.

Unlike universally defined metrics found in standard financial statements, Adjusted Benchmark Free Cash Flow involves specific modifications to the traditional FCF calculation. These adjustments often aim to normalize the cash flow for unusual, non-recurring, or discretionary items, providing a clearer picture of a company's sustainable cash generation capacity. The "benchmark" aspect then involves comparing this adjusted figure to industry averages, best-in-class performers, or internal targets, allowing for a relative assessment of performance and identification of areas for improvement.

History and Origin

The concept of free cash flow itself evolved from earlier financial theories focused on intrinsic value. The foundational idea that the value of an asset is derived from its future income streams can be traced back to economists like John Burr Williams, whose 1938 text, The Theory of Investment Value, articulated the theory of discounted cash flow (DCF) based on the present value of future dividends¹¹. Over time, this evolved to include free cash flows, recognizing that not all earnings are immediately distributed as dividends and that a company's value also stems from the cash it can generate after funding its operations and growth. The practical application of discounted cash flow analysis gained significant traction in corporate finance and investment valuation, particularly after the stock market crash of 1929.

The "adjusted" component reflects the ongoing need for financial analysts and corporate management to tailor metrics for specific analytical purposes. As companies grew more complex and financial reporting became more nuanced, the desire to strip away distortions from standard figures led to the creation of various non-GAAP (Generally Accepted Accounting Principles) measures. The U.S. Securities and Exchange Commission (SEC) has provided guidance on the use and disclosure of non-GAAP financial measures, emphasizing the need for transparency and reconciliation to comparable GAAP measures⁹, ¹⁰.

The "benchmark" aspect is rooted in the long-standing practice of benchmarking in business, where organizations compare their performance metrics and processes to those of industry leaders or competitors to identify areas for improvement. This practice has become increasingly sophisticated, leveraging data and analytical tools to provide granular insights into operational and financial efficiency⁷, ⁸. The combination of adjusted cash flow with benchmarking allows for a more insightful comparison than simple raw data.

Key Takeaways

• Adjusted Benchmark Free Cash Flow is a non-standardized metric used to assess a company's cash-generating ability relative to a chosen benchmark after accounting for specific adjustments.
• It provides a refined view of sustainable cash flow, excluding non-recurring or distorting items that might be present in reported operating activities or net income.
• The adjustments aim to normalize free cash flow for clearer comparative analysis, making it more useful for strategic decision-making and performance evaluation.
• Benchmarking allows for a relative assessment, indicating how well a company performs compared to peers or industry best practices.
• Due to its customized nature, Adjusted Benchmark Free Cash Flow requires careful definition and consistent application for meaningful interpretation.

Formula and Calculation

While there isn't a single universal formula for Adjusted Benchmark Free Cash Flow, it typically begins with a standard free cash flow (FCF) calculation, followed by specific adjustments and a subsequent comparison to a benchmark. A common starting point for FCF (specifically, free cash flow to firm, or FCFF) involves:

Where:

• ( EBIT ) = Earnings Before Interest and Taxes (EBIT)
• ( Tax \ Rate ) = Corporate tax rate
• ( Depreciation \ & \ Amortization ) = Non-cash expenses added back
• ( Change \ in \ Working \ Capital ) = Change in current assets minus current liabilities, excluding cash
• ( Capital \ Expenditures ) = Investments in long-term assets, often referred to as CapEx

The "Adjusted" part of Adjusted Benchmark Free Cash Flow then involves modifications to this base FCF, which could include:

• Excluding non-recurring gains or losses (e.g., one-time asset sales, legal settlements).
• Normalizing discretionary spending (e.g., unusually high or low research and development, or marketing spend).
• Accounting for specific industry-related cash flow dynamics not captured by standard metrics.
• Removing the impact of unusual working capital fluctuations.

After these adjustments, the resulting "Adjusted Free Cash Flow" is then benchmarked. This benchmarking can involve:

• Comparing the metric to that of direct competitors.
• Comparing it to industry averages.
• Comparing it to internal targets or historical performance.

Interpreting the Adjusted Benchmark Free Cash Flow

Interpreting Adjusted Benchmark Free Cash Flow involves understanding both the "adjusted" value itself and its comparison to the "benchmark." A higher Adjusted Benchmark Free Cash Flow relative to the benchmark typically indicates superior financial health and operational efficiency within the context of the adjustments made.

For instance, if a company's Adjusted Benchmark Free Cash Flow significantly exceeds its industry peer group, it suggests that the company is more effective at converting its operations into distributable cash, even after accounting for specific financial nuances or non-recurring events. This strong cash flow generation provides greater financial flexibility, allowing management to pursue growth initiatives, repay debt, or return capital to shareholders. Conversely, an Adjusted Benchmark Free Cash Flow below the benchmark might signal inefficiencies, excessive capital needs, or challenges in generating sustainable cash from core operations.

Analysts often use this metric to assess a company's inherent profitability and its capacity to create shareholder value without being swayed by transient accounting figures. The key to accurate interpretation lies in understanding the specific adjustments made and the relevance and comparability of the chosen benchmark.

Hypothetical Example

Consider "Tech Innovate Inc.," a growing software company, wanting to evaluate its cash-generating efficiency. Management believes that standard Free Cash Flow (FCF) doesn't fully capture its sustainable performance due to significant, but temporary, investments in a new data center and a one-time legal settlement. They decide to calculate Adjusted Benchmark Free Cash Flow for the fiscal year.

Tech Innovate Inc. Financial Data (Year 1):

• Earnings Before Interest and Taxes (EBIT): $100 million
• Tax Rate: 25%
• Depreciation & Amortization: $15 million
• Change in Working Capital: -$5 million (outflow due to increased inventory)
• Capital Expenditures (CapEx): $40 million (includes $15 million for new data center)
• One-time Legal Settlement Inflow (after tax): $10 million

Step 1: Calculate Standard Free Cash Flow (FCF)

Step 2: Apply Adjustments for Adjusted Benchmark Free Cash Flow
Management identifies the following adjustments:

• Excess CapEx: The $15 million spent on the new data center is considered a non-recurring, growth-related capital expenditure beyond what is needed for maintenance. It is subtracted from the CapEx amount.
• One-time Legal Settlement: The $10 million inflow is non-operating and non-recurring. It is subtracted from the cash flow.

Adjusted CapEx = $40 million (Total CapEx) - $15 million (Excess CapEx) = $25 million
Adjusted FCF (before legal settlement) = $75M + $15M + $5M - $25M = $70M
Adjusted Benchmark Free Cash Flow = $70M - $10M = $60M

Step 3: Benchmark Comparison
Tech Innovate Inc. benchmarks against its closest peer, "Software Solutions Co.," which reported an FCF of $50 million for the same period. The industry average for Adjusted FCF (with similar adjustments) is $58 million.

Interpretation:
Tech Innovate Inc.'s Adjusted Benchmark Free Cash Flow of $60 million is higher than its standard FCF of $55 million, reflecting the impact of the one-time events. More importantly, it surpasses the industry average of $58 million, suggesting that Tech Innovate Inc. demonstrates superior operational efficiency in generating sustainable cash flows compared to its peers when normalized for specific factors. This information could be crucial for investors evaluating the company's long-term potential and its ability to return capital to shareholders.

Practical Applications

Adjusted Benchmark Free Cash Flow serves multiple practical applications across investing, corporate finance, and strategic planning.

• Investment Decisions: Investors and analysts utilize this metric to gain a clearer understanding of a company's intrinsic value, beyond what might be presented by traditional earnings figures. By adjusting for unusual items and comparing to benchmarks, investors can identify companies with robust and sustainable cash generation, which is a key driver of long-term returns. For example, investment firms often look for companies with healthy free cash flow because it suggests a promising future and the ability to expand business operations or pursue other investments⁶.
• Performance Evaluation: Companies regularly use Adjusted Benchmark Free Cash Flow to evaluate the effectiveness of their operational strategies. By comparing their adjusted cash flow to industry leaders or internal targets, management can identify strengths and weaknesses, pinpoint areas for cost reduction, and optimize capital allocation. This also helps in setting more realistic and challenging performance goals.
• Mergers and Acquisitions (M&A): In M&A due diligence, potential acquirers often calculate Adjusted Benchmark Free Cash Flow to assess the true, normalized cash-generating capability of a target company. This helps in determining a fair acquisition price and understanding the potential synergies or integration challenges related to cash flow.
• Capital Allocation Strategy: A clear understanding of Adjusted Benchmark Free Cash Flow informs decisions about how to allocate capital. Companies with strong adjusted cash flow might prioritize share buybacks, dividend payments, debt reduction, or strategic investments, whereas those with weaker figures might focus on improving operational efficiency or divesting non-core assets.
• Lending and Credit Analysis: Creditors may use Adjusted Benchmark Free Cash Flow to assess a company's ability to service its debt obligations. A consistent, strong adjusted cash flow profile indicates a lower risk of default and greater capacity for future borrowing.

Limitations and Criticisms

While Adjusted Benchmark Free Cash Flow offers valuable insights, it also comes with several limitations and criticisms that users must consider for a balanced perspective.

One primary limitation stems from its non-standardized nature. Unlike GAAP metrics, there is no universal definition for what constitutes an "adjustment" or how a "benchmark" should be chosen. This subjectivity can lead to inconsistencies between companies or even within the same company over different periods, making true comparisons challenging. Different analysts might make different adjustments based on their assumptions, leading to widely varying Adjusted Benchmark Free Cash Flow figures for the same entity. The SEC has cautioned against non-GAAP measures that could be misleading, particularly those that exclude normal, recurring, cash operating expenses, emphasizing the need for transparent reconciliation to GAAP measures⁴, ⁵.

Another criticism relates to the potential for manipulation. Since adjustments are discretionary, management could potentially use them to present a more favorable cash flow picture than reality. For example, by classifying recurring operational expenses as "non-recurring" adjustments, a company could inflate its Adjusted Benchmark Free Cash Flow, making its performance appear stronger than it is.

Furthermore, selecting an appropriate benchmark can be difficult. An ideal benchmark should consist of truly comparable companies in terms of industry, business model, size, and geographic markets. Misleading comparisons can arise if the benchmark group is not carefully selected or if underlying differences are not accounted for. Benchmarking data can also be backward-looking, which may not always be relevant for fast-evolving industries or during periods of significant economic change³.

Finally, the focus on Adjusted Benchmark Free Cash Flow might sometimes distract from other important financial indicators. While cash flow is crucial, a holistic financial assessment requires considering profitability (e.g., net income, margins), solvency (e.g., debt levels), and liquidity (e.g., current ratio). Relying solely on one adjusted metric, no matter how insightful, can lead to an incomplete or biased view of a company's overall financial health.

Adjusted Benchmark Free Cash Flow vs. Free Cash Flow

The distinction between Adjusted Benchmark Free Cash Flow and standard Free Cash Flow (FCF) lies primarily in the level of customization and the inclusion of comparative analysis.

In essence, standard Free Cash Flow (FCF) provides a general measure of a company's cash-generating ability. Adjusted Benchmark Free Cash Flow takes this a step further, tailoring the FCF figure to remove specific distortions and then explicitly comparing it to a relevant benchmark, offering a more nuanced and context-specific analytical tool.

FAQs

What does "adjusted" mean in this context?

"Adjusted" refers to modifications made to a company's standard free cash flow (FCF) calculation. These modifications typically involve adding back or subtracting non-recurring, unusual, or discretionary items that might obscure the true, sustainable cash-generating ability of the business. The goal is to normalize the cash flow for a clearer analysis.

Why is benchmarking important for this metric?

Benchmarking is crucial because it provides a frame of reference. By comparing the adjusted cash flow to an industry average, a competitor, or an internal target, analysts can assess how well a company is performing relative to its peers or its own goals. It helps identify whether a company is underperforming or outperforming and highlights areas for improvement.

Is Adjusted Benchmark Free Cash Flow a GAAP metric?

No, Adjusted Benchmark Free Cash Flow is a non-GAAP (Generally Accepted Accounting Principles) metric. It is a customized measure developed for specific analytical purposes and is not defined or mandated by accounting standards. Companies that publicly report such adjusted figures are generally required by the SEC to reconcile them to the most comparable GAAP measure and explain their usefulness¹, ².

How does it differ from other cash flow measures?

Unlike basic cash flow from operations, which shows cash generated before capital investments, Adjusted Benchmark Free Cash Flow accounts for necessary capital expenditures and then goes further by making specific "adjustments" to the resulting free cash flow. This makes it a more refined measure focused on sustainable, discretionary cash. Its benchmarking component also sets it apart, focusing on comparative performance rather than just absolute value.

Can small businesses use Adjusted Benchmark Free Cash Flow?

Yes, while often used by larger corporations and sophisticated investors, the principles behind Adjusted Benchmark Free Cash Flow can be adapted by small businesses. A small business owner might adjust their cash flow for non-recurring personal expenses or unusual one-time investments, and then benchmark it against industry averages for their size and sector to assess their operational efficiency and growth potential.