Free Cash Flow from the Statements

Step 1: Adding Back Depreciation & Amortization (D&A)

Depreciation & Amortization (D&A) is the accounting mechanism that spreads the cost of a long-lived asset — machinery, equipment, buildings, or an acquired intangible like a customer list or patent — over that asset's useful life, instead of expensing the full purchase price in the year it was bought. D&A reduces Net Income on the income statement, but critically, no cash actually leaves the business in the period D&A is recorded — the real cash outflow happened earlier, when the asset was originally purchased (or is captured separately in Step 3 as CapEx, if the spending happened this year). Because Free Cash Flow is a purely cash-based measure and Net Income is an accrual-accounting measure, this non-cash charge has to be added straight back to undo its effect.

Net Income + D&A = $300 + $150 = $450.0

Step 2: Adding Back the After-Tax Interest Expense

Interest Expense is a financing cost — it reflects how the company chose to fund itself (with debt), not how well the underlying business operates. Unlevered Free Cash Flow is deliberately capital-structure-neutral: it's meant to show the cash the business generates for all capital providers — both lenders and shareholders — regardless of how much debt the company happens to carry. Since Interest Expense was already subtracted on the way to Net Income, it has to be added back here.

The subtlety is that Interest Expense is tax-deductible, meaning it lowered the company's tax bill — an effect known as the interest tax shield. That tax saving was real cash the company kept, so we can't just add back the full, pre-tax Interest Expense; doing so would overstate UFCF by ignoring the fact that some of that "expense" was effectively subsidized by lower taxes. Instead, we add back only the after-tax portion — the amount left once the tax shield has been netted out.

After-Tax Interest Expense = Interest Expense × (1 - Tax Rate) = $80 × (1 - 0.25) = $80 × 0.75 = $60.0

Running Subtotal = $450.0 + $60.0 = $510.0

Step 3: Subtracting Capital Expenditures (CapEx)

Capital Expenditures (CapEx) is the actual cash a company spends buying, building, or upgrading long-term physical assets — new machinery, a facility expansion, IT infrastructure, and so on. Unlike D&A, CapEx is a real, current-period cash outflow, but here's the part that trips candidates up: it never shows up on the income statement at all. Under accrual accounting, the cash spent on a new asset is capitalized onto the balance sheet and then expensed gradually over time through D&A, rather than hitting the income statement in one lump sum in the year of purchase. That's exactly why CapEx has to be pulled in as a separate line here — if you only added back D&A and stopped, you would have accounted for the accounting expense of past capital spending, but completely ignored the real cash spent on capital investment this year.

Running Subtotal - CapEx = $510.0 - $180 = $330.0

Step 4: Adjusting for the Change in Net Working Capital (NWC)

Net Working Capital (NWC) is the cash tied up in a business's day-to-day operating cycle — primarily receivables (money owed by customers), inventory (goods not yet sold), and payables (money the company owes suppliers). A growing business typically needs to fund more receivables and inventory as sales increase, which consumes cash even though it shows up nowhere on the income statement; conversely, if the company can stretch out payments to its own suppliers (i.e., Accounts Payable grows), that frees up cash instead of using it.

The convention is: an increase in an operating asset (Accounts Receivable, Inventory) is a use of cash and gets added when computing the increase in NWC; an increase in an operating liability (Accounts Payable) is a source of cash and gets subtracted. The resulting "increase in NWC" figure is then itself subtracted from Free Cash Flow, because a positive increase in NWC means cash left the business to fund operations.

Increase in NWC = Increase in AR + Increase in Inventory - Increase in AP = $40 + $25 - $20 = $45.0

Unlevered Free Cash Flow = Running Subtotal - Increase in NWC = $330.0 - $45.0 = $285.0

Final Results

• Subtotal after D&A and after-tax interest add-backs: $510.0
• Subtotal after CapEx: $330.0
• Increase in Net Working Capital: $45.0
• Unlevered Free Cash Flow: $285.0

Put together, the full build is: UFCF = Net Income + D&A + Interest Expense × (1 - Tax Rate) - CapEx - Increase in NWC = $300 + $150 + $60.0 - $180 - $45.0 = $285.0. This is exactly the figure that feeds the projection years of a DCF model — each year's Unlevered FCF gets discounted back at the company's WACC and summed with the discounted terminal value to arrive at Enterprise Value. Because UFCF is capital-structure-neutral, this same $285.0 would be identical whether Meridian financed itself entirely with equity or took on significantly more debt; only Levered Free Cash Flow — which keeps interest expense and mandatory debt repayments in the calculation — would change with the financing mix.

Would you like to explore how this calculation changes if Meridian's Net Working Capital had actually decreased instead of increased, or how Levered Free Cash Flow would differ from this Unlevered figure?