<p>When you manufacture a product, you incur some production cost. However, you do not account for this production cost in the <span class="math-container">$\text{Cost}$</span> line of the income statement until you actually sell the product. While the product is sitting in your inventory waiting to be sold, you have already incurred some (actual, monetary) cost that is not visible in the <span class="math-container">$\text{Cost}$</span> line. That is why you have to adjust the reported <span class="math-container">$\text{Cost}$</span> by <span class="math-container">$\Delta\text{Inventory}$</span> to obtain the actual, monetary cost for the period. </p>

<p>This is why <span class="math-container">$\Delta\text{Inventory}$</span> belongs in the FCF calculation.</p>

CC BY-SA 4.0
2019-05-15T12:47:04.423Z
Inspired by Kym Ellis ["3 Costly Mistakes Related to Free Cash Flow"](https://www.payability.com/blog/3-costly-mistakes-related-to-free-cash-flow/). I hope I got the idea right.
Richard Hardy
CC BY-SA 4.0
2019-05-15T12:46:14.610Z
2019-05-15T13:33:28.087Z
2019-05-15T13:33:28.087Z
Richard Hardy
<p>Free cash flow (FCF) can be obtained by 
<span class="math-container">$$
\text{FCF}=(\text{Revenues}-\text{Cost}-\text{Depreciation})(1-\tau)+\text{Depreciation}-\text{Capital Expenditures}-\Delta(\text{Net Working Capital})
$$</span>
where <span class="math-container">$\tau$</span> is the corporate tax rate and
<span class="math-container">$$
\Delta(\text{Net Working Capital})=\Delta(\text{Cash}+\text{Inventory}+\text{Receivables}-\text{Payables})
$$</span>
is the increase in net working capital over the period of interest. Besides inventory, all of these items appear to be monetary, except for depreciation which only affects the FCF through taxation, and so that contribution is also monetary. </p>

<p>But what about inventory? A change in inventory does not generate any monetary gains or losses, or does it? If it does not, how come a change in inventory is included in the calculation of the FCF?</p>

<corporate-finance>
Relevance of change in Inventory in calculation of Free Cash Flow
Richard Hardy
# Relevance of change in Inventory in calculation of Free Cash Flow

(Asked by: username_0 on 2019-05-15)

Free cash flow (FCF) can be obtained by
$$
\text{FCF}=(\text{Revenues}-\text{Cost}-\text{Depreciation})(1-\tau)+\text{Depreciation}-\text{Capital Expenditures}-\Delta(\text{Net Working Capital})
$$
where $\tau$ is the corporate tax rate and
$$
\Delta(\text{Net Working Capital})=\Delta(\text{Cash}+\text{Inventory}+\text{Receivables}-\text{Payables})
$$
is the increase in net working capital over the period of interest. Besides inventory, all of these items appear to be monetary, except for depreciation which only affects the FCF through taxation, and so that contribution is also monetary.

But what about inventory? A change in inventory does not generate any monetary gains or losses, or does it? If it does not, how come a change in inventory is included in the calculation of the FCF?

**Tags:** corporate-finance


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## 1 answers

### Answer by username_0 on 2019-05-15. Score: 1

When you manufacture a product, you incur some production cost. However, you do not account for this production cost in the $\text{Cost}$ line of the income statement until you actually sell the product. While the product is sitting in your inventory waiting to be sold, you have already incurred some (actual, monetary) cost that is not visible in the $\text{Cost}$ line. That is why you have to adjust the reported $\text{Cost}$ by $\Delta\text{Inventory}$ to obtain the actual, monetary cost for the period.

This is why $\Delta\text{Inventory}$ belongs in the FCF calculation.

> **Comments:**
> **username_0**: Inspired by Kym Ellis ["3 Costly Mistakes Related to Free Cash Flow"](https://www.payability.com/blog/3-costly-mistakes-related-to-free-cash-flow/). I hope I got the idea right.  

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