Question

1.  Link the definitions of NOPAT and FCF. Invoking extreme simplicity, how would you describe NOPAT to a colleague? How would you map FCF with respect to NOPAT, net fixed asset investment, and net working capital?

2. NOPAT and FCF are likely of limited use in a vacuum (i.e., one year). Accordingly, explain why ROIC, MVA, and EVA—and the historical trends thereof—are important performance metrics in a financial analysis exercise.

Answer 1

1.a. In addition to providing analysts with a measure of core operating efficiency without the influence of debt, mergers and acquisitions analysts use net operating profit after tax. They use this to calculate free cash flow to firm (FCFF) , which equals net operating profit after tax, minus changes in working capital. They also use it in the calculation of economic free cash flow to firm (FCFF), which equals net operating profit after tax minus capital. Both are primarily used by analysts looking for acquisition targets, since the acquirer's financing will replace the current financing arrangement. Another way to calculate net operating profit after tax is net income plus net after-tax interest expense, or net income plus net interest expense, multiplied by 1, minus the tax rate.

b. NOPAT is an acronym that stands for Net Operating Profit After Tax. The measurement is a good way to understand the underlying profitability of a business by stripping away the effects of financing, since its primary focus is on earnings generated by operations. NOPAT is particularly effective when comparing the results of several companies in the same industry that employ different financing structures, since the results will exclude the effects of financing. Otherwise, the results of a highly leveraged company would likely be seen to spike or drop in relation to the results of other companies with more conventional financing structures.

However, NOPAT should not be used to compare companies in different industries, since the operations of these organizations will still have essentially different cost structures. Thus, the NOPAT of a capital-intensive manufacturing organization may be quite different from the NOPAT of a services business.

If a company has no financing costs or interest income, then NOPAT is the same as net income. Thus, NOPAT is not especially useful for a company that has little or no debt. In this situation, a simple net income calculation should be sufficient for interpreting the results of an organization.

The formula for NOPAT is as follows:

Net operating income x (1 - tax rate)

c. FCF = NOPAT - Change in Net Working Capital - Change in Fixed Assets