Prepared by: Nir Yehuda

With contributions by
Stephen H. Penman Columbia University
Peter D. Easton and Gregory A. Sommers - Ohio State University
Luis Palencia University of Navarra, IESE Business School

What you will learn from this chapter

How free cash flow can be calculated from reformulated income
statements and balance sheets without a cash flow statement
How the cash conservation equation ties the cash flow statement
together to equate free cash flow and financing cash flow
The difference between the direct and indirect calculations of
cash from operations
Problems that arise in analyzing cash flows from GAAP
statements of cash flow
What reformulated cash flow statements tell you
How free cash flow changes typically over a products life cycle

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-3

The Calculation of Free Cash Flow

Three methods to calculate FCF:

1. Use the sources of cash flow equation:

C - I = OI - NOA
that is, free cash flow is operating income adjusted for the change in net
operating assets
2. Use the disposition of cash flows equation:

C - I = NFE - NFO + d
that is, free cash flow is net financial expenses, adjusted for the change in
net financial obligations, plus dividends to common shareholders.
3. FCF can also be obtained from the reformulated Statement of Cash Flows.

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-4

Calculation of Free Cash Flow:

Nike, Inc.: 1996
C I = OI -

Method 1:
Operating income 1996
Net operating assets 1996
Net operating assets 1995
Free cash flow

$ 549
$ 2,659
2,208

1996

(451)
$98

C I = NFE - FO + d

Method 2:
Net financial expenses 1996
Net financial obligations 1996
Net financial obligations 1995

$ 14
$ 228
244

16

Net dividend

1996

68

Free cash flow

1996

$98

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-5

Calculation of Free Cash Flow:

Reebok, 1996

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-6

The Standard GAAP Statement of Cash Flows

Standard Statement of Cash Flows
Cash Flow from Operations
- Cash Used in Investing Activities
+ Cash from Financing Activities
= in Cash and Cash Equivalents

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-7

Reformulated Statement of Cash Flows

Cash flow from Operations
- Cash investments
=Free Cash Flow from Operating
Activities
Cash Paid to Shareholders
+ Cash Paid to Debtholders and Issuers
=Cash Paid for Financing Activities

This format follows the cash conservation equation:

CI=d+F
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-8

Year ended May

1996

1995

1994

______________________________________________________________________________________
Cash provided (used) by operations:
Net income

Nike, Inc.
GAAP Statement of
Cash Flows

Income charges (credits) not affecting cash:

Depreciation
Deferred income taxes and purchased tax benefits
Other liabilities
Amortization and other
Changes in certain working capital components:
(Increase) decrease in inventory
(Increase) decrease in accounts receivable
(Increase) decrease in other current assets
Increase (decrease) in accounts payable, accrued
liabilities and income taxes payable

$553,190

$399,664

$298,794

97,179
(73,279)
465)
35,199

71,113
(24,668)
(1,359)
19,125

(301,409)
(292,888)
(20,054)

(69,676)
(301,648)
(10,276)

160,823
23,979
6,888

332,548

172,638

40,845

330,021

254,913

576,463

Additions to property, plant and equipment

Disposals of property, plant and equipment
Additions to other assets
Acquisition of subsidiaries:
Identifiable intangible assets and goodwill
Net assets acquired

(216,384)
12,775
(26,376)

(154,125)
9,011
(6,260)

(95,266)
12,650
(5,450)

---

(345,901)
(84,119)

(2,185)
(1,367)

Cash used by investing activities

(229,985)

(581,394)

(91,618)

5,044
(30,352)
47,964
21,150
(18,756)
(78,834)

2,971
(39,804)
263,874
6,154
(142,919)
(65,418)

6,044
(56,986)
(2,939)
4,288
(140,104)
(60,282)

Cash provided by operations

64,531
(23,876)
(3,588)
8,067

Cash provided (used) by investing activities:

Cash provided (used) by financing activities:

Additions to long-term debt
Reductions in long-term debt
Increase (decrease) in notes payable
Proceeds from exercise of options
Repurchase of stock
Dividends common and preferred

McGraw-Hill/Irwin

Cash provided (used) by financing activities

(53,784)

Effect of exchange rate changes on cash

Net (decrease) increase in cash and equivalents
Cash and equivalents, beginning of year

(206)
46,046
216,071

24,858
(1,122)
(302,745)
518,816

(249,979)
(7,334)
227,532
291,284

Cash and equivalents, end of year

$262,117

$216,071

$518,816

Supplemental disclosure of cash flow of information:

Cash paid during the year for:
Interest (net of amount capitalized)

$ 32,800

$ 20,200

$ 11,300

The McGraw-Hill Companies, Inc., 2003 All rights

10-9

Problems with the Standard Statement

1. Change in operating cash should be included in the investment
section, and the change in cash equivalents in the financing section
2. Transactions in financial assets are included in the investments
section rather than in the financing section
3. Cash interest is included in the operating rather than in the
financing section
4. Tax cash flows are all included in the operating section, and not
allocated to operating and financing
5. The statement does not incorporate non-cash transactions

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-10

1. Operating Cash and Cash in Financial Assets:

Nike
Change in cash and cash equivalents

$46 million

Increase in operating cash

Increase in financial assets

$7 million
39______
$46 million

The determination of operating cash: use a normal percentage of

sales for the industry

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-11

2. Transactions in Financial Assets: Lucent

Technologies
Fiscal Year Ending September

Net income
Cash from operating activities

1999

1998

1997

4,766

1,035

449

(276)

1,860

2,129

(2,215)

(1,791)

(1,744)

97
(307)
156
(450)
1,132
72
(264)
61
(69)

57
(212)
71
(1,082)
686
329
(1,078)
(80)

108
(149)
12
(483)
356
181
(1,584)
(68)

(1,787)

(3,100)

(3,371)

682

(396)

(127)

2,469

2,704

3,244

Cash in investing activities:

Capital expenditures
Proceeds from the sale or
disposal of property, plant and equipment
Purchases of equity investments
Sales of equity investments
Purchases of investment securities
Sales or maturity of investment securities
Dispositions of businesses
Acquisitions of businesses - net of cash acquired
Cash from mergers
Other investing activities - net
Net cash used in investing activities

Net sales of financial assets

Adjusted cash investment in operations
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-12

3. and 4. Net Interest Payments and Taxes on Net Interest

Payments: Nike
Interest payments
Interest income
Net interest payments
before tax
Tax benefit (at 38.5%)

$32,800
(16,000)
(16,800)
6,468
$10,332

Add back to GAAP cash from operations

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-13

5. Non-cash Transactions

Acquisitions with shares

Asset exchanges
Assets acquired with debt
Capitalized leases
Installment purchases
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-14

The Reformulated Statement of Cash Flows: the

Adjustments
GAAP Free Cash Flow

GAAP Financing Flow

+ Net cash interest outflow (after tax)

+ Net cash interest outflow (after tax)

+ Investments in financial assets

- Noncash financing

- Sale of financial assets

+ Purchase of financial assets

- Noncash investments

- Sales of financial assets

- Increase in operating cash

+ Increase in cash equivalents

- Investment in operating assets on installment basis

= Financing Cash Flow

= Free Cash Flow

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-15

Nike, Inc. Reformulated Statement of Cash Flows

Free Cash Flow
Reported cash from operations
Net interest paid after tax
Cash investments reported
Investment in operating cash
Free cash flow
Financing Flow to Claimants
Debt financing:
Additions to long-term debt
Reductions to long-term debt
Increase in notes payable
Net interest paid, after taxes
Investments in cash equivalents
Equity financing
Share issues (from exercise of options)
Purchases of shares
Dividends
Total financing flows

McGraw-Hill/Irwin

330
10
340
230
7

(5)
30
(48)
10
39
(21)
19
79

The McGraw-Hill Companies, Inc., 2003 All rights

237
103

26

77
103

10-16

Why Free Cash Flow from Adjusted Cash Flow

Statements May not Reconcile to the Methods 1 and 2
Other assets and other liabilities are not identified as
either operating or financing
Cash dividends in the cash flow statement differ from
dividends in the equity statement
Cash from share issues in the cash flow statement may
differ from share issues in the equity statement
Details for adjustments 3,4 and 5 are not available
Cash flow numbers are translated at average exchange rates
whereas balance sheet numbers are translated at end-ofyear exchange rates
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-17

The Calculation of Cash Flow from Operations

The practical matter of distinguishing cash flow from
operations from cash flow from investment activities is not an
easy one: the cash flow from operations in the GAAP statement
is not a clean measure.
Some cash flows from investment activities are classified as
cash flows from operations
R&D expenditures
Investment in inventories

Taxes on gains from assets sales are classified as cash flow

from operations
Note, however, that for a calculation of FCF (C I), a
misclassification between investment and operating activities
has no effect
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-18

The Quality of the Reported Cash Flow from Operations

(CFO) Number as an Indicator of Profitability
Non cash charges do not affect CFO, but are a loss of value
(e.g. depreciation)
Taxes benefits of stock options are included in CFO but not
the compensation expense
Firms can delay payments to generate cash flow
Firms can sell receivables to generate cash flow
Firms can reduce advertising expenditures to generate cash
flow
Firms can reduce R&D expenditures to generate cash flow
Non-cash transactions are not in CFO
McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003 All rights

10-19