GSK’s cash conversion – calculating adjustments on top of relevance adjustment

Published January 31, 2016

Disclosure: I’m long GlaxoSmithKline plc (GSK)

In “GSK’s cash conversion – systematic guesswork“, I gave figures for the leakage between core profit after tax and free cash flow, and then gave “relevance adjusted” versions (for example I removed the effect of changes in working capital). I then needed to make further adjustments, to get the leakage between Profit attributable to shareholders, and the sum of Free cash flow and Proceeds from sale of intangible assets. I’ll abbreviate the terms in that last sentence, to get the formula:

conversion = (FCF + Proceeds) / Shareholders profit

In this case I can’t put the actual FCF into the formula, instead I need to use the FCF that’s implied by my judgments about relevance (for example, assuming that changes in working capital will be zero, which is probably a reasonable approximation per year over a long period). To avoid confusion, I’ll change the formula to:

conversion = (Implied FCF + Proceeds) / Shareholders profit

where Implied FCF = Core profit after tax * Conversion rate adjusted for relevance. I’ll be using “PAT” for “profit after tax”, and I’ll write leakage rates or conversion rates as either proportions or percentages, for example 0.1234 and 12.34% are different formats for the same rate.

For the period 2012 to Q3 2015

Core PAT = 19,363
assumed leakage PAT to FCF (adjusted for relevance) = 0.2894
Proceeds = 1,522
Shareholders profit = 18,325

Because the conversion rate is 1 minus the leakage rate:
assumed conversion PAT to FCF (adjusted for relevance) = 1 – 0.2894 = 0.7106

Implied FCF = Core PAT * Conversion rate adjusted for relevance
= 19,363 * 0.7106
= 13,759

I now have the numbers to put into the formula
conversion = (Implied FCF + Proceeds) / Shareholders profit
conversion = (13,759 + 1,522) / 18,325
= 15,281 / 18,325
= 0.8339

The leakage is 1 minus that,
= 0.1661, or 16.61%.

Before adjusting for the profit attributable to non-controlling interests, and proceeds from sale of intangibles, the “relevance adjusted” leakage figure was 28.94%, and the adjustments have brought the leakage figure down by 12.33% (to 16.61%).

For the period 2012 to 2014

Core PAT = 16,248
assumed leakage PAT to FCF (adjusted for relevance) = 0.1824
Proceeds = 1,522
Shareholders profit = 15,541

Because the conversion rate is 1 minus the leakage rate:
assumed conversion PAT to FCF (adjusted for relevance) = 1 – 0.1824 = 0.8176

Implied FCF = Core PAT * Conversion rate adjusted for relevance
= 16,248 * 0.8176
= 13,284

I now have the numbers to put into the formula
conversion = (Implied FCF + Proceeds) / Shareholders profit
conversion = (13,284 + 1,522) / 15,541
= 14,806 / 15,541
= 0.9527

The leakage is 1 minus that,
= 0.0473, or 4.73%.

Before adjusting for the profit attributable to non-controlling interests, and proceeds from sale of intangibles, the “relevance adjusted” leakage figure was 18.24%, and the adjustments have brought the leakage figure down by 13.51% (to 4.73%).

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