Adjusted free profit

What Is Adjusted Free Profit?

Adjusted Free Profit is a non-Generally Accepted Accounting Principles (non-GAAP) financial metric that aims to provide a refined view of a company's financial performance by modifying its cash flow beyond standard definitions. It typically starts with a measure of free cash flow and then applies further adjustments to reflect what management considers the true discretionary cash available to equity holders, after accounting for all necessary operational and strategic outlays. As a metric within corporate finance and financial analysis, Adjusted Free Profit attempts to offer a clearer picture of a company's underlying profitability and capacity for generating surplus cash, unencumbered by certain recurring or non-recurring expenditures that might distort traditional measures like net income.

History and Origin

The evolution of financial reporting has seen a continuous refinement of how a company's economic health and capacity to generate cash are measured. While the cash flow statement has been a formally required part of financial statements in the United States since 1988 (Statement of Financial Accounting Standards No. 95), the concept of "free cash flow" itself gained prominence earlier. Michael Jensen is often credited with introducing the concept of free cash flow in the context of the agency problem in 1986, though he did not propose a specific calculation method.⁸

Over time, various interpretations and calculations of free cash flow emerged, leading companies and analysts to create customized metrics that they believe better reflect specific aspects of a company's cash-generating ability. Adjusted Free Profit arises from this trend, representing a further tailoring of the free cash flow concept to suit particular analytical needs or to highlight management's view of core distributable earnings. The increasing use of non-GAAP measures has prompted the U.S. Securities and Exchange Commission (SEC) to issue guidance to ensure such metrics are not misleading and are reconciled to comparable GAAP measures.⁷

Key Takeaways

• Adjusted Free Profit is a non-GAAP metric that provides a customized view of a company's discretionary cash flow.
• It typically modifies standard free cash flow to exclude or include specific items deemed non-core or strategic by management.
• This metric is used to assess a company's capacity to return capital to investors through dividends or share repurchases, reduce debt, or pursue strategic initiatives.
• Interpreting Adjusted Free Profit requires a clear understanding of its specific adjustments and how they deviate from GAAP measures.
• While offering deeper insights, Adjusted Free Profit can lack comparability across different companies due to its customized nature.

Formula and Calculation

Adjusted Free Profit builds upon the foundation of Free Cash Flow. While the exact formula for Adjusted Free Profit can vary significantly as it is a non-GAAP measure defined by the entity presenting it, a common starting point is Free Cash Flow.

Free Cash Flow (FCF) is typically calculated as:

Where:

• Cash Flow from Operating Activities represents the cash generated by a company's normal business operations.
• Capital Expenditures are the funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment.

To arrive at Adjusted Free Profit, additional adjustments are made to this FCF. For example, a company might define Adjusted Free Profit as:

Where:

• Strategic Investment Cash Outflows might include significant cash outlays for new product development, acquisitions, or market expansion that management views as distinct from typical capital expenditures or core operations.
• Non-Recurring Cash Inflows could represent one-time cash receipts, such as proceeds from asset sales, that are not expected to recur in the normal course of business.

These adjustments aim to present a "cleaner" measure of cash generated from ongoing, core operations that is available for discretionary uses, such as enhancing shareholder value.

Interpreting the Adjusted Free Profit

Interpreting Adjusted Free Profit requires careful consideration of the specific adjustments made by the company. A higher Adjusted Free Profit generally indicates a greater amount of surplus cash that a company has available for discretionary purposes, such as paying down debt, distributing dividends to shareholders, or engaging in share repurchases. For investors, a consistently strong Adjusted Free Profit figure can signal a healthy financial position and the potential for future capital returns or growth investments.

However, because Adjusted Free Profit is a non-GAAP metric, its interpretation must be done with caution. Analysts should understand precisely what is included in and excluded from the calculation. For example, if "strategic investment cash outflows" are removed, it might present a more favorable short-term cash picture, but it could obscure necessary long-term investments in the business. Conversely, excluding truly non-recurring items can provide a better sense of a company's sustainable cash-generating ability. Ultimately, it serves as a supplementary tool in financial analysis, providing management's unique perspective on their cash generation, which should always be reconciled with and understood in the context of standard financial statements.

Hypothetical Example

Consider "InnovateTech Inc.," a software company. For the fiscal year, its cash flow from operating activities was $100 million, and its capital expenditures were $20 million. This results in a Free Cash Flow of $80 million.

However, InnovateTech Inc. defines its Adjusted Free Profit by further subtracting cash spent on significant, non-recurring research and development (R&D) projects that are not part of its typical ongoing R&D budget but are considered strategic long-term bets. For the year, these strategic R&D cash outflows amounted to $15 million. Additionally, the company received a $5 million cash inflow from the sale of an old, non-core patent, which it considers a non-recurring item to be added back to represent operational cash available.

The calculation would be as follows:

1. Calculate Free Cash Flow (FCF):
   FCF = Cash Flow from Operating Activities - Capital Expenditures
   FCF = $100 million - $20 million = $80 million

2. Calculate Adjusted Free Profit:
   Adjusted Free Profit = FCF - Strategic R&D Cash Outflows + Non-Recurring Patent Sale Inflow
   Adjusted Free Profit = $80 million - $15 million + $5 million = $70 million

In this hypothetical example, InnovateTech's Adjusted Free Profit of $70 million indicates the cash surplus management believes is truly available after funding operations, maintaining assets, and making specific strategic investments, adjusted for one-time cash windfalls. This figure provides a specific lens into their cash-generating efficiency, focusing on core operations plus significant but defined strategic outlays.

Practical Applications

Adjusted Free Profit finds several practical applications, particularly within the realm of corporate finance and investment analysis, as a metric for assessing a company's financial flexibility and capacity for capital allocation.

• Capital Allocation Decisions: Companies utilize Adjusted Free Profit to inform decisions regarding how to deploy their surplus cash. This includes funding dividends, executing share repurchases, paying down debt, or investing in growth opportunities. Companies adept at capital allocation often prioritize the efficient use of their cash flow to maximize shareholder value.⁶
• Valuation Models: While standard Discounted Cash Flow (DCF) models typically use a more conventional free cash flow definition, analysts may use Adjusted Free Profit in customized valuation models to reflect specific assumptions about a company's sustainable distributable cash. This is especially relevant for companies with significant, yet volatile, non-recurring items or strategic investments.
• Performance Evaluation: Management may use Adjusted Free Profit as an internal performance metric, believing it better reflects the operational efficiency and discretionary cash generated by core business units than traditional GAAP measures.
• Creditor and Investor Analysis: Lenders and investors might look at Adjusted Free Profit to gauge a company's ability to service its debt and provide returns to equity holders, particularly if they believe standard free cash flow metrics do not fully capture the company's true cash generating capacity due to specific business activities or accounting nuances.

For instance, a company might announce adjusted free cash flow outlooks, which are similar in concept to Adjusted Free Profit, to communicate their expected cash generation to the market, often tying it to future capital allocation plans.⁵ Major financial data providers also track and analyze various forms of free cash flow, including proprietary adjusted methodologies, to provide valuation insights.⁴

Limitations and Criticisms

While Adjusted Free Profit can offer a tailored and potentially insightful view of a company's cash generation, it comes with significant limitations and criticisms, primarily due to its nature as a non-GAAP financial measure.

One major criticism stems from the lack of standardization. Since there is no universal definition for "Adjusted Free Profit," each company can define and calculate it differently. This makes cross-company comparisons challenging and potentially misleading, as what one company adjusts for, another might not.³ The U.S. Securities and Exchange Commission (SEC) has repeatedly issued guidance and interpretations regarding non-GAAP measures, emphasizing that they should not be presented in a misleading way or with greater prominence than comparable GAAP measures. The SEC's concerns include the exclusion of "normal, recurring, cash operating expenses" from non-GAAP performance measures, which could be misleading.²

Another limitation is the potential for manipulation or selective presentation. Management might choose adjustments that present the most favorable picture of the company's financial standing, rather than the most representative. This can obscure underlying operational issues or significant cash drains that would be apparent under standard accounting principles. For example, if critical but volatile capital expenditures are consistently "adjusted out," the reported Adjusted Free Profit might appear artificially high, masking a true need for ongoing investment to maintain or grow the business. Investors relying solely on such adjusted figures without understanding the full context and reconciliation to GAAP financial statements may misinterpret a company's true financial health.

Finally, the inherent subjectivity in determining which items constitute "adjustments" means that even well-intentioned adjustments can introduce bias. Analysts and investors must exercise due diligence, carefully scrutinizing the reconciliation of Adjusted Free Profit to its most directly comparable GAAP measure (such as cash flow from operating activities or total free cash flow) and understanding the rationale behind each adjustment.

Adjusted Free Profit vs. Free Cash Flow

While "Adjusted Free Profit" and "Free Cash Flow (FCF)" are both measures of a company's cash-generating ability, the key distinction lies in the level of customization and adherence to generally accepted definitions.

Adjusted Free Profit is essentially a modified version of free cash flow, tailored to highlight specific aspects of a company's financial performance. It begins with a base FCF calculation and then introduces further additions or subtractions that management deems relevant to a particular analytical objective. While FCF itself is not a GAAP measure, its calculation is generally consistent across financial analysis, making it a more universally understood and comparable metric than the potentially idiosyncratic Adjusted Free Profit. The adjustments in Adjusted Free Profit are typically designed to strip away items that management considers non-recurring, non-operational, or strategic and thus not reflective of the company's "true" core cash generation available for shareholder value enhancement or debt reduction.

FAQs

What is the primary difference between Adjusted Free Profit and traditional profit metrics like net income?

Adjusted Free Profit, like other cash flow measures, focuses on the actual cash generated and available to the company, whereas net income is an accrual-based accounting measure that includes non-cash items like depreciation and amortization. Adjusted Free Profit also goes a step further than standard free cash flow by incorporating management-defined adjustments.

Why do companies use non-GAAP metrics like Adjusted Free Profit?

Companies often use non-GAAP metrics to provide what they believe is a clearer picture of their operational performance, stripping out items they consider non-recurring, extraordinary, or non-cash that might obscure underlying trends. They aim to show the cash truly available for discretionary uses such as dividends or share repurchases.

Are there any regulatory concerns with Adjusted Free Profit?

Yes, as a non-GAAP measure, Adjusted Free Profit is subject to scrutiny from regulatory bodies like the SEC. The SEC requires companies to reconcile non-GAAP measures to their most directly comparable GAAP financial measure and ensures they are not presented in a misleading manner or with greater prominence than the GAAP equivalent.¹

How does Adjusted Free Profit relate to a company's valuation?

Adjusted Free Profit can be used in certain valuation models, particularly customized Discounted Cash Flow (DCF) analyses, to project future cash flows available to investors. However, analysts must be cautious and understand the specific adjustments, as using an overly optimistic or inconsistent Adjusted Free Profit can lead to inaccurate valuations.

What should an investor look for when analyzing a company's Adjusted Free Profit?

Investors should first understand the precise definition and calculation of Adjusted Free Profit used by the company. They should scrutinize the adjustments made, question their rationale, and always compare the Adjusted Free Profit to the company's GAAP-compliant financial statements, particularly the cash flow statement, to gain a complete and balanced view.