Here in Part 4, I will calculate the free cash flow of Fastenal for 2010. My method of calculating cash flow is based on that described in the book Cash Flow and Security Analysis by Kenneth Hackel and Joshua Livnat. However, please note that the Doppler method OMITS changes in current liabilities.
Why do I omit changes in current liabilities when calculating cash flow even though the conventional definition includes them? First, it makes companies look bad when they pay suppliers and look good when they don’t. Not paying suppliers is an unsustainable way to increase cash flow.
Second, the differences in the treatment of short-term and long-term liabilities is arbitrary. The classic definition of free cash flow would penalize a company that pays off a company that sells a bond (borrowing money from bondholders) and uses the proceeds to pay back suppliers. The reason for this is that money owed to suppliers is classified as short-term liabilities and part of operations while money owed to bondholders is classified as long-term liabilities and part of financing. Under the Doppler method, money owed to suppliers is considered to be part of financing. A company that sells a bond and uses the proceeds to pay back suppliers has merely replaced one liability with another and is no better and no worse off after the transaction than before. (In practice, the company may even be better off, because it doesn’t have to pay off this liability as soon and thus has more breathing room.)
For 2010, the cash flow components of Fastenal are:
Net sales (+): $2,269.471 million
Cost of sales (-): $1,094.635 million
Operating/admin expenses (-): $745.112 million
Depreciation (+): 40.688 million
Change in bad debt expense (+): 8.658 million
Stock-based compensation (+): 4.030 million
Amortization of non-compete (+): .067 million
Change in trade accounts receivable (+): -64.622 million
Change in inventories (+): -48.964 million
Change in other current assets (+): -24.577 million
Fastenal’s cash flow for 2010 is $345.004 million. Note that depreciation, bad debt expense, stock-based compensation, and amortization do not constitute an explicit expenditure of cash but are included in the entries that penalize our calculation of cash flow (namely cost of sales or operating/admin expenses).
Cash flow is penalized by increases in receivables, inventories, and other current assets. An increase in receivables increases the sales but does NOT add cash, because the money hasn’t been collected yet. (Companies have gone under as a result of extending too much credit and not being able to collect on it.) An increase in inventories or other current assets means that cash has been spent but not yet counted as an expense. The expense of increasing inventories isn’t recorded until the inventory is sold or gets written off. Prepaid expenses aren’t counted as expenses until the service is actually used. (Companies have gone under as a result of purchasing too much inventory and being unable to sell it.)
Not all of a company’s cash flow can actually be saved. Every year, some of the plant, property, and equipment must be replaced because it has worn out or become obsolete. The cash flow remaining after necessary capital expenditures is free cash flow, because it’s free for the company to use for expanding operations, for paying dividends, or for the treasury.
I could subtract all capital expenditures from cash flow, but that would unfairly penalize companies that are expanding and unfairly reward companies that are shrinking. Another method is to use the formula:
NCAP(Y) = PPE(Y-1) + CAP_EXP(Y) – CAP_DIV(Y) – PPE(Y)
where NCAP (Y) = this year’s normalized capital spending, PPE (Y-1) = last year’s plant/property/equipment at cost, CAP_EXP(Y) = this year’s capital expenditures, CAP_DIV(Y) = this year’s capital divestitures, and PPE (Y) = last year’s plant/property/equipment at cost. The problem with this method is that any acquisitions or divestitures that take place will throw off these calculations. However, from the analysis I have done, most companies need to spend between 5% and 10% of their PPE to maintain it. Please note that the PPE figures are the original cost figures, NOT the depreciated value (which is subject to arbitrary accounting methods).
To be conservative, I assume that a company needs to spend 10% of its PPE to maintain it. Note that the PPE value for the year Y-1 is also the PPE value for the start of the year Y. Thus, the formula for normalized capital spending is:
NCAP(Y) = .1 * PPE(Y-1)
At the end of 2009 (beginning of 2010), Fastenal’s PPE at cost was $571.467 million. This means that normalized capital spending for 2010 was $57.147 million. Subtracting it from the cash flow of $345.004 million gives us a free cash flow of $287.857 million. The net liquidity of -$10.859 million is probably not a problem given that this is less than 4% of the year’s free cash flow.
