Skip to main content
Message Font: Serif | Sans-Serif
No. of Recommendations: 2
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.


Print the post  


When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.