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Chapter 10

Chapter 10. 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.

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Chapter 10

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  1. Chapter 10 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

  2. 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 product’s life cycle

  3. The Calculation of Free Cash Flow • Three methods to calculate FCF: • Use the sources of cash flow equation: that is, free cash flow is operating income adjusted for the change in net operating assets • Use the disposition of cash flows equation: that is, free cash flow is net financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. • FCF can also be obtained from the reformulated Statement of Cash Flows.

  4. Calculation of Free Cash Flow: Nike, Inc.: 1996

  5. Calculation of Free Cash Flow:Reebok, 1996

  6. The Standard GAAP Statement of Cash Flows

  7. Reformulated Statement of Cash Flows This format follows the cash conservation equation: C – I = d + F

  8. Nike, Inc. GAAP Statement of Cash Flows

  9. Problems with the Standard Statement • Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section • Transactions in financial assets are included in the investments section rather than in the financing section • Cash interest is included in the operating rather than in the financing section • Tax cash flows are all included in the operating section, and not allocated to operating and financing • The statement does not incorporate non-cash transactions

  10. 1. Operating Cash and Cash in Financial Assets: Nike Change in cash and cash equivalents $46 million Increase in operating cash $7 million Increase in financial assets 39______ $46 million The determination of operating cash: use a normal percentage of sales for the industry

  11. 2. Transactions in Financial Assets: Lucent Technologies

  12. 3. and 4. Net Interest Payments and Taxes on Net Interest Payments: Nike Interest payments $32,800 Interest income (16,000) Net interest payments before tax (16,800) Tax benefit (at 38.5%) 6,468 $10,332 Add back to GAAP cash from operations

  13. 5. Non-cash Transactions • Acquisitions with shares • Asset exchanges • Assets acquired with debt • Capitalized leases • Installment purchases

  14. The Reformulated Statement of Cash Flows: the Adjustments

  15. Nike, Inc. Reformulated Statement of Cash Flows

  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-of-year exchange rates

  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

  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

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