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I am evaluating several companies that have made acquisitions through the year. If I take working capital numbers from the balance sheet, am I double-couting the acquistions (since cash acq's are included in fixed capital)? Cash Flows from Ops. on the Statement of Cash Flow excludes acquisitions and divestitures. Therefore, the changes in working capital in my spreadsheet do not match what the company list under Op. CF.

Any help would be greatly appreciated.

Hewitt- Terrific book! I've included your Earnings Power methodolgy in my firm's investment process.
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Matt -

If company A acquires company B, B's receivables, inventory, payables, and accrued expenses (as well as fixed assets) are added to A's balance sheet.

So when you calculate A's free cash flow, A benefits from B's extra sales and earnings but suffers from the added working capital.

Take a look at CVS, for example. In July 2004 it bought 1,268 Eckerd retail drugstores and Eckerd Health Services. While CVS's 2004 net income was $72.5 million above 2003, operating cash flow declined $(54.7) million. Earnings quality watchers say when these two numbers diverge, that's a red flag.

In CVS's case, however, year-end 2004 working capital assets included an additional $1,314 million of receivables and inventory, and an extra $823 million of payables and accrued expenses. So the incremental increase in net working capital from the Eckerd deal is $491 million. Remember, increases in net working capital are a use of cash in the defensive income statement (free cash flow). In other words, if CVS had not acquired the Eckerd drugstores, then its operating cash flow would be $491 million higher than 2003's results. (For you sticklers, I realize that the Eckerd income contribution should be subtracted, but I do not know what that amount is and I am trying to keep things simple.)

This is an astute observation on your part, and an issue that doesn't get enought attention.

So that I do not penalize companies like CVS, I check if they made any acquisitions during the year and then adjust for acquired working capital. It takes a little bit of extra work. Also, it makes year-over-year comparisons more difficult.


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Thanks, Hewitt. That is exactly what I needed to know.

If the co doesn't break out the working capital additions from the acq. in the footnotes, do you then pull the numbers off the Statement or CFs?
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Companies will disclose this information in a special SEC filing.

If we are talking a few dollars here and there, do not sweat it. But in the case of CVS's '04 purchase of Eckerd, it is a big deal.
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