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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.


Hewitt

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