Inventory Swings

Inventory swings in the simulation (and the real world) can be large, but if you average the swings over several years, they too average towards zero. Therefore, Inventory swings are a Working Capital issue, not a Free Cash Flow issue.

In the end we are left with Profits plus Depreciation plus small fluctuations we can ignore.

Cash Flow Statement Survey		Andrews	Baldwin	Chester
Cash flows from operating activities
Net Income (Loss)		$708	$5,304	$1,572
Adjustment for non-cash items
Depreciation		$8,013	$9,040	$7,960
Extraordinary gains/losses/writeoffs		$0	$0	$251
Changes in current assets and liabilities
Accounts payable		($1,029)	$6,215	$3,425
Inventory		$3,406	($4,934)	($1,304)
Accounts receivable		$206	($3,306)	($383)
Net cash from operations		$11,304	$12,318	$11,520
Cash flows from investing activities
Plant improvements (net)		($6,400)	($25,300)	($12,180)
Cash flows from financing activities
Dividends paid		$0	$0	$0
Sales of common stock		$0	$5,000	$6,000
Purchase of common stock		$0	$0	$0
Cash from long term debt issued		$0	$10,000	$6,000
Retirement of long term debt		$0	$0	$0
Change in current debt		$0	$0	$0
Net cash from financing activities		$0	$15,000	$12,000
Net Change in Cash Position		$4,904	$2,018	$11,340
Free Cash Flow		$4,904	($12,982)	($660)

Even if Profit is small, Depreciation would continue to deliver a Cash Flow From Operations. Indeed, in the early years of the simulation, Depreciation is usually larger than Profits. However, you never actually write a check for Depreciation, yet it was deducted as an expense from your Income Statement. The money is sitting in the Cash account like a check that has not been cashed. It follows that the next thing Free Cash Flow must do is subtract Capital Expenditures, the investments in plant and equipment. If it turns out that you are plowing money back into plant at the same rate you are depreciating it, the whole business reduces back to our old friend, profits.

Still, there is a lot of noise here, and Free Cash Flow cuts through it. If the result is a positive number, then the company is creating wealth. The Free Cash Flow can be used to pay dividends, repurchase stock, or reinvest in the company, any of which delights Owners. If negative, then the company needs to consume somebody's wealth, and there are only three places to get it — working capital (our own wealth), a new stock issue (Owner's wealth), or more debt (Lender's wealth).

In any particular year, swings in inventory or profits could push Free Cash Flow negative, but over several years the swings should cancel out. Therefore, the Wealth Creation category uses Cumulative Free Cash Flow to measure your success.