Adjusted free free cash flow

What Is Adjusted Free Cash Flow?

Adjusted free cash flow refers to a modified version of a company's free cash flow (FCF), tailored by analysts or management to better reflect the true discretionary cash available to the business or its investors, after accounting for specific items deemed unusual, non-recurring, or essential for ongoing operations. Unlike standard free cash flow, which typically subtracts only capital expenditures from cash flow from operations, adjusted free cash flow incorporates further adjustments. These adjustments often aim to present a clearer picture of operational efficiency and liquidity, particularly in the realm of financial analysis and valuation. By making these modifications, stakeholders can gain deeper insights into a company's ability to generate cash that can be used for debt repayment, dividends, share buybacks, or growth initiatives.

History and Origin

The concept of "free cash flow" itself gained prominence as financial reporting evolved to provide a more comprehensive view beyond traditional accrual accounting. Prior to the late 1980s, financial statements often emphasized changes in financial position or working capital. However, with the issuance of Financial Accounting Standards Board (FASB) Statement No. 95, "Statement of Cash Flows," in November 1987, the present-day statement of cash flows became a mandatory part of a complete set of financial statements for U.S. companies.¹², ¹³, ¹⁴ This pivotal development provided a standardized framework for classifying cash receipts and payments into operating, investing, and financing activities, laying the groundwork for the calculation of cash flow metrics like free cash flow.¹¹

As analysts sought more precise measures for corporate valuation and performance assessment, the need arose to "adjust" free cash flow for idiosyncratic company-specific factors or non-recurring events that might distort the underlying, sustainable cash-generating capacity. This led to the informal, yet widely practiced, development of adjusted free cash flow, tailored to specific analytical needs rather than adhering to a single, universally defined accounting standard.

Key Takeaways

• Adjusted free cash flow modifies traditional free cash flow to reflect a company's discretionary cash more accurately.
• It typically involves adding back or subtracting items that are considered non-recurring, unusual, or critical for an analyst's specific valuation objective.
• This metric is widely used in valuation models, particularly discounted cash flow analysis, to project future cash flows.
• Adjusted free cash flow provides a more nuanced view of a company's financial health and its capacity to fund operations, growth, and shareholder returns.
• Due to its flexible nature, the specific adjustments made can vary significantly between analysts and companies.

Formula and Calculation

Adjusted free cash flow does not have a single, universally accepted formula, as the "adjustments" are inherently subjective and dependent on the analyst's or company's specific objective. However, it generally starts with a standard free cash flow calculation and then incorporates additional line items.

A common starting point for free cash flow to the firm (FCFF) is:

Where:

• (\text{EBIT}) = Earnings Before Interest and Taxes
• (\text{Tax Rate}) = Corporate income tax rate
• (\text{Depreciation}) = Non-cash charges related to asset usage
• (\text{Capital Expenditures}) = Cash spent on acquiring or maintaining fixed assets
• (\Delta \text{Working Capital}) = Change in working capital (current operating assets minus current operating liabilities)

To arrive at Adjusted Free Cash Flow, an analyst might make further modifications. For example, if a company reports an unusually high one-time legal settlement expense that impacted its operating cash flow, an analyst might add this back to arrive at a normalized figure. Conversely, if certain recurring, yet often excluded, maintenance capital expenditures are essential for the business to continue operating at its current capacity, they might be specifically factored in.

Another common starting point is net income, with various adjustments for non-cash items and investment activities.

Interpreting the Adjusted Free Cash Flow

Interpreting adjusted free cash flow requires understanding the specific adjustments made and the rationale behind them. A higher positive adjusted free cash flow generally indicates a stronger ability for a company to generate cash from its core operations after funding necessary investments to maintain or expand its asset base. This suggests robust financial health and flexibility.

Analysts often use adjusted free cash flow as a key input in discounted cash flow (DCF) models to estimate a company's intrinsic value. By projecting future adjusted free cash flow, they can discount these future cash flows back to the present using an appropriate discount rate, such as the Weighted Average Cost of Capital (WACC), to arrive at a valuation. The goal of adjustments is to make the forecasted cash flows more representative of the ongoing, sustainable cash generation rather than being skewed by one-off events or non-standard practices. This metric provides a more refined perspective on how much cash is truly available for distribution to all capital providers.

Hypothetical Example

Consider "TechInnovate Inc.," a software company, whose income statement and balance sheet data reveal the following for the year:

• Net Income: $100 million
• Depreciation & Amortization: $20 million
• Capital Expenditures: $15 million
• Change in Non-Cash Working Capital: -$5 million (decrease in working capital, which is a cash inflow)
• One-time restructuring charge (non-cash): $10 million (this was an accounting write-off, not a cash outflow)
• Proceeds from asset sales (non-operating): $8 million

First, let's calculate a standard Free Cash Flow (FCFF) starting from Net Income:

FCFF = Net Income + Depreciation & Amortization - Capital Expenditures - Change in Non-Cash Working Capital (accounting for sign convention)
FCFF = $100M + $20M - $15M - (-$5M)
FCFF = $100M + $20M - $15M + $5M
FCFF = $110 million

Now, let's calculate Adjusted Free Cash Flow, assuming an analyst wants to remove the impact of the one-time non-cash restructuring charge and the non-operating asset sales to focus purely on core operational cash generation:

Adjusted Free Cash Flow = FCFF + One-time Non-Cash Restructuring Charge - Proceeds from Asset Sales (as they are non-recurring and not from core operations)
Adjusted Free Cash Flow = $110M + $10M - $8M
Adjusted Free Cash Flow = $112 million

In this hypothetical example, the adjusted free cash flow of $112 million provides a more normalized view of TechInnovate Inc.'s underlying cash-generating capability, excluding the temporary boosts or drags from non-recurring events.

Practical Applications

Adjusted free cash flow is a crucial metric with several practical applications across various financial disciplines:

• Investment Analysis: Equity analysts frequently use adjusted free cash flow to assess a company's intrinsic value. By adjusting for non-recurring items or specific strategic investments, they can build more reliable projections for future cash flows, forming the basis for discounted cash flow models.
• Corporate Finance: Companies themselves may use adjusted free cash flow to communicate their underlying financial performance to investors, especially when significant one-time events have impacted reported GAAP cash flows. However, such "non-GAAP" measures must be clearly explained and reconciled to their most directly comparable GAAP measures, as guided by the U.S. Securities and Exchange Commission (SEC).⁸, ⁹, ¹⁰
• Credit Analysis: Lenders and credit rating agencies may look at adjusted free cash flow to evaluate a company's capacity to service its debt financing obligations and meet future liquidity needs. Adjustments can help to clarify sustainable cash generation versus temporary fluctuations.
• Mergers and Acquisitions (M&A): In M&A deals, buyers analyze the target company's adjusted free cash flow to understand the cash flow they can expect to generate from the acquired entity, informing their valuation and structuring of the transaction.
• Strategic Planning: Management teams use adjusted free cash flow insights for internal strategic planning, capital allocation decisions, and assessing the effectiveness of operational initiatives, focusing on the cash truly available for reinvestment or distribution to shareholders through equity financing.

Limitations and Criticisms

While providing a flexible and often insightful view, adjusted free cash flow comes with its own set of limitations and criticisms:

• Subjectivity: The primary criticism stems from its subjective nature. What one analyst considers an "adjustment" necessary for normalization, another might view as an integral part of the business or an inappropriate manipulation of numbers. This lack of standardization can make comparisons between companies or analysts difficult.
• Potential for Manipulation: Because it is a non-GAAP (Generally Accepted Accounting Principles) measure, companies have significant discretion in defining and presenting adjusted free cash flow. This discretion can, in some cases, be used to present a more favorable financial picture, potentially misleading investors if not adequately explained and reconciled to GAAP metrics. The SEC provides guidance on the appropriate use and disclosure of non-GAAP financial measures to mitigate such risks.⁶, ⁷
• Ignoring Reality: Some adjustments, particularly those that remove "non-recurring" expenses, might ignore that such events, while individually non-recurring, are collectively a recurring feature of doing business (e.g., small legal settlements, asset impairments). Overly aggressive adjustments can paint an unrealistically rosy picture of a company's cash-generating ability.
• Complexity: The more adjustments made, the more complex the calculation becomes, potentially obscuring the underlying simplicity of cash flow analysis and making it harder for less experienced investors to understand.
• Forecasting Challenges: Projecting adjusted free cash flow into the future for valuation purposes can be challenging. The very nature of "adjustments" often relates to unpredictable events, making future normalization difficult to forecast accurately. Academic research notes the challenges in valuation by using discounted free cash flow methods, highlighting complexities in determining free cash flows, cost of capital, and terminal value.³, ⁴, ⁵

Adjusted Free Cash Flow vs. Free Cash Flow

The primary distinction between Adjusted Free Cash Flow and Free Cash Flow (FCF), particularly Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE), lies in the degree of customization and the specific purpose of the calculation.

Free Cash Flow (FCF), in its standard definitions (FCFF or FCFE), typically refers to the cash generated by a company's operations that is available to all capital providers (FCFF) or only equity holders (FCFE) after accounting for all operating expenses and necessary capital investments. Its calculation usually follows a relatively straightforward path from the statement of cash flows or through adjustments to net income. These are widely accepted concepts within financial accounting and valuation methodologies, as taught by institutions like the CFA Institute.¹, ²

Adjusted Free Cash Flow, on the other hand, takes the standard FCF as a starting point and applies further, often discretionary, modifications. These adjustments are made by an analyst or management to filter out specific items that might distort the core, ongoing cash-generating capacity of the business. For example, a company might present "adjusted free cash flow" by excluding cash outflows for a major acquisition, assuming it's a one-time event not reflective of routine operations. The aim is to create a more "normalized" or "core" cash flow figure, often for comparative analysis or to highlight underlying operational performance. The confusion arises because while standard FCF is a common non-GAAP measure itself (as it’s derived from GAAP operating cash flow by subtracting capital expenditures), "adjusted" FCF implies additional non-standard modifications.

FAQs

Why do companies report adjusted free cash flow?

Companies often report adjusted free cash flow to provide a clearer picture of their underlying operational performance and cash-generating ability, especially when one-time events or specific strategic investments might obscure the view of their routine cash flows. It's used to help stakeholders understand the cash truly available for distribution or reinvestment.

Is adjusted free cash flow a GAAP measure?

No, adjusted free cash flow is typically a non-GAAP (Generally Accepted Accounting Principles) financial measure. It involves modifications that go beyond the standardized rules of financial accounting. Companies are required by the SEC to reconcile any non-GAAP measure to its most directly comparable GAAP measure.

What kinds of adjustments are typically made?

Adjustments can vary widely but often include adding back or subtracting cash flows related to non-recurring events (like large one-time legal settlements or asset sales), certain acquisition-related expenses, or specific types of capital expenditures that an analyst deems non-essential for maintaining current operations. The goal is to present a "cleaner" view of core cash generation.

How does adjusted free cash flow differ from operating cash flow?

Operating cash flow, reported on the statement of cash flows, represents the cash generated from a company's normal business activities. Free cash flow typically subtracts capital expenditures from operating cash flow. Adjusted free cash flow goes a step further by making additional, often discretionary, modifications to the free cash flow figure to suit a specific analytical purpose.