Breaking Into Wall Street - The 3 Financial Statements

($ in Thousands)

Tax Rate: 40.0%

Income Statement: Balance Sheet: Cash Flow Statement:

Start of End of
Revenue: $ 700 Assets: Period Period Cash Flow from Operating Activities:
Cost of Goods Sold (COGS): 70 Current Assets: Net Income: $ 135
Gross Profit: 630 Cash: $ 300 $ 660 Depreciation: 10
Gross Margin %: 90.0% Short-Term Investments: - - Amortization of Intangible Assets: 10
Accounts Receivable: - 50 Stock-Based Compensation: 20
Operating Expenses: Inventory: - 30 Goodwill Impairment: 50
Sales & Marketing: 165 Prepaid Expenses: - 30 PP&E Write-Down: 10
Research & Development: 75 Total Current Assets: 300 770 Deferred Income Taxes: 50
General & Administrative: 50 (Gains) / Losses on Investment Sales: 15
Total Operating Expenses: 290 Long-Term Assets: Change in Operating Assets & Liabilities:
Property, Plant & Equipment: - 30 Change in Accounts Receivable: (50)
Depreciation: 10 Goodwill: 100 50 Change in Inventory: (30)
Amortization of Intangible Assets: 10 Other Intangible Assets: 50 40 Change in Prepaid Expenses: (30)
Stock-Based Compensation: 20 Long-Term Investments: - 100 Change in Accounts Payable: 15
Total Long-Term Assets: 150 220 Change in Accrued Expenses: 10
Operating Income (EBIT): 300 Change in Deferred Revenue: 15
Operating Margin: 42.9% Total Assets: $ 450 $ 990 Cash Flow from Operations: $ 230

Other Income / (Expenses): 20 Liabilities & Equity: Cash Flow from Investing Activities:
Interest Income / (Expense): (20) Current Liabilities: Capital Expenditures (CapEx): $ (50)
Goodwill Impairment: (50) Revolver (Short-Term Debt): $ - $ 50 Purchases of Short-Term Investments: (100)
PP&E Write-Down: (10) Accounts Payable: - 15 Purchases of Long-Term Investments: (100)
Gains / (Losses) on Investment Sales: (15) Accrued Expenses: - 10 Proceeds from ST Investment Sales: 85
Deferred Revenue: - 15 Cash Flow from Investing: $ (165)
Pre-Tax Income (EBT): 225 Total Current Liabilities: - 90
Cash Flow from Financing Activities:
Income Taxes: 90 Long-Term Liabilities: Debt Raised: $ 300
Current Portion: 40 Debt: - 240 Debt Principal Repayment: (60)
Deferred Portion: 50 Deferred Tax Liability: - 50 Revolver Issued / (Repaid): 50
Total Long-Term Liabilities: - 290 Equity Issuance: 100
Net Income (Profit After Taxes): $ 135 Dividends Issued: (50)
Net Income Margin: 19.3% Equity: Share Repurchases: (50)
Common Stock & Additional Paid-In Capital: 50 170 Cash Flow from Financing: $ 290
Retained Earnings: 400 485
Treasury Stock: - (50) FX Rate Effects: 5
Accumulated Other Comprehensive Income: - 5
Total Equity: $ 450 $ 610 Net Change in Cash: $ 360

Total Liabilities & Equity: $ 450 $ 990 Beginning Cash Balance: $ 300
Ending Cash Balance: $ 660
BALANCE CHECK: OK! OK!

Free Cash Flow: $ 180

Table of Contents for This Lesson:

1. What Free Cash Flow (FCF) is, and Why It's Important.

2. What if FCF is positive? What does that mean, and what do you do with it?

3. What if FCF is negative? What does it tell you about the company's operations?

4. Why do you exclude certain items, such as investing and financing activities, from the FCF calculation?

5. How do you use and interpret FCF when analyzing and valuing companies?

6. FCF Comparison and Interpretation for Wal-Mart, Amazon, and Salesforce.

7. Recap and Summary.

What is "Free Cash Flow" and Why Does It Matter?
What Does Free Cash Flow Mean? Wal-Mart vs. Amazon vs. Salesforce
($ in Million Except Per Share Data)

Wal-Mart - FCF Excerpt from Financial Statements: Amazon - FCF Exc

Free Cash Flow Calculation: Year 1 Year 2 Year 3

Cash Flow from Operations: $ 23,643 $ 24,255 $ 25,591 $ 23,257
Less: Capital Expenditures: (12,699) (13,510) (12,898) (13,115)
Free Cash Flow: $ 10,944 $ 10,745 $ 12,693 $ 10,142

Changes In Certain Assets and Liabilities: Year 1 Year 2 Year 3

Accounts Receivable: $ (796) $ (614) $ (566)
Inventories: (3,727) (2,759) (1,667)
Accounts Payable: 2,687 1,061 531
Accrued Liabilities: (935) 271 103
Accrued Taxes: 994 981 (1,224)
Net Change in (Operating) Working Capital: (1,777) (1,060) (2,823)

Annual Revenue: $ 421,395 $ 446,509 $ 468,651 $ 476,294

Annual Net Income: 16,993 16,387 17,756 16,695

Net Change in WC % Change in Revenue: (7.1%) (4.8%) (36.9%)

Free Cash Flow Growth Rate: (1.8%) 18.1% (20.1%)

CapEx as a % of Cash Flow from Operations: 55.7% 50.4% 56.4%
CapEx as a % of Revenue: 3.0% 2.8% 2.8%

Revenue Growth Rate: 6.0% 5.0% 1.6%

Cash Flow from Operations Growth Rate: 2.6% 5.5% (9.1%)

Interpretation: FCF seems to be all over the place - falling, rising, falling again… Cash Flow from Ops
was MOSTLY growing except for the decline in Year 3 - due to Accrued Taxes.

Revenue is certainly growing over time, but WC and CapEx impact FCF in a huge, unpredictable way.

Not exactly "playing games" with Working Capital, but it did change something significantly in
Year 2, which pushed down its overall requirements even as revenue increased.

So, bottom-line: not the worst we've seen, but it's hard to buy into organic sales growth alone
contributing to the growth in Free Cash Flow. Some contribution, but some of it was also due
to CapEx and Working Capital changes.

Recap: So What Does Free Cash Flow Mean?

Roughly, Cash Flow from Operations minus CapEx.

"Discretionary cash flow" - after paying for what's required, how much does the company have
left for other uses?

Paying for more employees, more on CapEx, more acquisitions, repay debt, invest in other
assets, buy other companies, issue dividends or repurchase shares, spend on WC…

Or, does the company need more funding because it has a cash flow shortfall?

Used in a DCF analysis (variation), LBO analysis, and standalone growth / financial statement
analysis, to determine a company's value, debt repayment capacity, what else it might do
with the excess cash it generates.

It's really important to dig in and see what's driving Free Cash Flow - organic revenue growth?
Expense cutting? CapEx or Working Capital changes?

BEST is when organic sales and economies of scale are driving growth - less good is when it's
inconsistent, or expense/CapEx cutting is driving it.

And even worse is when "games" and accounting gimmicks are affecting FCF and distorting the picture.

We'll see many examples of how to calculate and project this in the upcoming modules.
Amazon - FCF Excerpt from Financial Statements: Salesforce - FCF Excer

Free Cash Flow Calculation: Year 1 Year 2 Year 3

Cash Flow from Operations: $ 3,495 $ 3,903 $ 4,180 $ 5,475
Less: Capital Expenditures: (979) (1,811) (3,785) (3,444)
Free Cash Flow: $ 2,516 $ 2,092 $ 395 $ 2,031

Changes In Operating Assets and Liabilities: Year 1 Year 2 Year 3

Accounts Receivable: $ (866) $ (861) $ (846)
Inventories: (1,777) (999) (1,410)
Accounts Payable: 2,997 2,070 1,888
Accrued Liabilities: 1,067 1,038 736
Deferred Revenue: 43 275 399
Net Change in (Operating) Working Capital: 1,464 1,523 767

Annual Revenue: $ 34,204 $ 48,077 $ 61,093 $ 74,452

Annual Net Income: 1,152 631 (39) 274

Net Change in WC % Change in Revenue: 10.6% 11.7% 5.7%

Free Cash Flow Growth Rate: (16.9%) (81.1%) 414.2%

CapEx as a % of Cash Flow from Operations: 46.4% 90.6% 62.9%
CapEx as a % of Revenue: 3.8% 6.2% 4.6%

Revenue Growth Rate: 40.6% 27.1% 21.9%

Cash Flow from Operations Growth Rate: 11.7% 7.1% 31.0%

Interpretation: CapEx jumping around so much that it's hard to say anything substantial about
Free Cash Flow here - huge ramp-up in spending in the past 2 years.

Revenue is growing at a good clip, and that is genuinely contributing to FCF growth because
Cash Flow from Operations is also increasing - but Amazon is clearly also investing a huge amount
into future growth, and we don't know what the payoff of that will be.

Good investment / strategy / company? Depends on how useful you think that CapEx spending
is… perhaps?

Not really "playing games" with Working Capital, but it is interesting how much the items
have changed over time - the Accounts Payable changes really stand out, but that actually
reduces cash flow for Amazon.
Salesforce - FCF Excerpt from Financial Statements:

Free Cash Flow Calculation: Year 1 Year 2 Year 3

Cash Flow from Operations: $ 459 $ 592 $ 737 $ 875
Less: Capital Expenditures: (91) (152) (176) (299)
Free Cash Flow: $ 368 $ 440 $ 561 $ 576

Changes In Operating Assets and Liabilities: Year 1 Year 2 Year 3

Accounts Receivable: $ (245) $ (183) $ (425)
Deferred Commissions: (167) (233) (265)
Prepaid Expenses: (8) (10) 105
Accounts Payable: 80 193 (29)
Deferred Revenue: 445 479 612
Net Change in (Operating) Working Capital: 105 247 (1)

Annual Revenue: $ 1,657 $ 2,267 $ 3,050 $ 4,071

Annual Net Income: 70 (12) (270) (232)

Net Change in WC % Change in Revenue: 17.2% 31.5% (0.1%)

Free Cash Flow Growth Rate: 19.5% 27.6% 2.7%

CapEx as a % of Cash Flow from Operations: 25.6% 23.8% 34.2%
CapEx as a % of Revenue: 6.7% 5.8% 7.3%

Revenue Growth Rate: 36.8% 34.6% 33.5%

Cash Flow from Operations Growth Rate: 28.8% 24.6% 18.8%

Interpretation: FCF is genuinely growing each year, but we don't really buy into the Year 2
number because CapEx as a % of revenue also fell quite a bit… and then rose in Year 3.

Genuine revenue growth, and since it's flowing down to Cash Flow from Operations, the company
isn't manipulating its numbers with Working Capital policies (at least, not to the extent that other
companies may).

Interesting Points Here: Will it continue to spend a lot on acquisitions and other activities with
its FCF? Still quite a bit left after paying for CapEx each year.

And… what are its future CapEx plans? Seems to a bit all over the place right now, which is impacting
the numbers here.

If CapEx as a % of revenue will stay low, it's possible the company will continue to spend a lot on acquisitions,
or perhaps even issue dividends or repurchase shares in the future.