To build a house, you must first have an architectural design and blueprints. However, if you were to just stop there, the only thing to exist would be sheets of paper. The same holds true for free cash flow. Understanding the basic concepts and definitions of free cash flow is a good start, but to realize the usefulness and value of this metric, you must develop the components of free cash flow brick by brick. This involves starting with the raw materials of net income and the balance sheet and transforming those raw materials into the finished products of net operating profit after taxes and invested capital. Without this building process, you are left with only the basic blueprints of free cash flow with nothing to show for it.
The first step in your building process is to create the net operating profit after taxes, or NOPAT, statement. The bricks you will use to create this statement are the income statement adjustments that need to be made when viewing company performance on an economic basis. By the time you are done building this structure, you will have a firm understanding of the actual economic flows of your company.
The next step is to build the invested capital statement. This requires using either the balance sheet assets and short-term liabilities or the long-term liabilities and equity as your raw materials, and then adjusting those components brick by brick to create a brand new statement that illustrates the amount of capital your company has invested in its business.
Armed with the building blocks of NOPAT and invested capital, you are ready to build your free cash flow statement. An added benefit of having created these building blocks is that they can also be used to determine the kind of return your business is earning on its invested capital. Ultimately, by actually building free cash flow brick by brick, a structure is created that will lead to sustainable value creation for your company.
Do you know how to determine the free cash flow of your company using these building blocks? The Accenture Academy course Calculating Free Cash Flow
can help you understand these building blocks and use them to generate sustainable value creation for your company by determining free cash flow and return on investment.