Defining Free Cash Flow

By John Mills, Lynn Bible, and Richard Mason

In Brief

Lack of a Consensus Calculation

It is not unusual to pick up an analysts' report, quarterly statement, or annual report and find references to a company's cash flow or free cash flow. But what do these terms really mean? There are many ways to define cash flow and free cash flow, resulting in problems of consistency and comparability. The authors use data from actual companies to illustrate the problems created by different calculations of cash flow. It is time to make better use of the statement of cash flows and derive a more consistent calculation of cash flow and free cash flow.

While companies, analysts, and investors realize the importance of cash flow, there is no real consensus on the definition of cash flow or free cash flow (see the Sidebars for sample definitions). This can lead to considerable misinterpretation when investors are relying on differing cash flow information provided by companies. It is imperative to reach a consensus about the meaning of the terms cash flow and free cash flow because financial analysts routinely use such terms in their reports and companies provide their own calculations of them in the management's discussion and analysis and financial highlights sections of their annual reports.

Cash Flow

Analysts and creditors know that an accurate measurement and projection of a company's ability to generate cash is critical to gauging its debt-service capability and overall debt capacity. Prior to the 1987 issuance of SFAS 95, Statement of Cash Flows, both groups suggested adding back depreciation as a means to derive cash flows. Analysts developed a surrogate for cash flows that in its simplest form was defined as "net profit plus depreciation." Creditors, on the other hand, wanted a figure that represented cash available to meet principal and interest payments, so they devised a calculation of earnings before interest, taxes, depreciation, and amortization (EBITDA). Before SFAS 95, EBITDA was analysts' and creditors' best available surrogate for a company's cash available to meet principal and interest payments. Surrogate cash flow information is still used even though cash flow from operations is readily obtained from SFAS 95's statement of cash flows (SCF). The accounting profession should insist that disclosures in financial reports not call a measure "cash from operations" unless it accords with SCF.

Despite the popularity of EBITDA, it has many shortcomings that users should consider. EBITDA is not true cash flow because it ignores many non-cash adjustments and the need to fund working capital changes (e.g., expanded inventory and receivables as sales expand). EBITDA also omits the payment of interest and taxes, debt service, and other fixed charges. Another important shortcoming is that EBITDA fails to take into consideration other non-cash transactions that are common in the income statement. For these and other reasons, the SEC objects to use of EBITDA.

For example, if a company has limited stock investments in another company (less than 20%), current practice requires recognition of the unrealized gains or losses on changes in the value of the stock. These unrealized gains and losses impact shareholders' equity but do not generate cash. If ownership is greater than 20%, the company recognizes a percentage of the investees' income or loss even though no dividends were paid or cash received. This can result in substantial earnings differences flowing through the income statement without the attendant cash effects. Other common transactions include gains and losses on the sale of fixed assets and impairment charges. Needless to say, there are many other transactions that result in substantial differences between accrual accounting income and cash flow from transactions.

SFAS 95 provides users with relevant information about the receipts and payments of cash during a period. It categorizes these receipts and payments into operating activities, investing activities, and financing activities. The cash flow from operating activities (CFO), taken from the SCF, is derived by taking net income or loss and adjusting it for both non-cash transactions and changes in working capital. It provides the cash generated from the current operating cycle rather than the surrogate amount under EBITDA. Exhibit 1 uses data from Mandalay Resort (formerly Circus Circus) to show how, for the 10 years provided, EBITDA is materially greater than CFO.

Free Cash Flow

Some analysts refer to free cash flow (FCF) as a basis for measuring a company's ability to meet continuing capital requirements. Others argue that FCF should represent the cash available after meeting all current commitments, that is, required payments made to continue operations (including dividends, current debt repayment, and regular capital reinvestment to maintain current operating activities). Still others argue that FCF should represent the cash available after meeting operating expenses, including working capital additions and the cost of maintaining operating assets. This approach defines FCF as "CFO minus capital maintenance expenditures." International Accounting Standard (IAS) 7 recommends that FCF should be recognized as "cash from operations less the amount of capital expenditures required to maintain the firm's present productive capacity." Using this description, dividends and mandatory debt payments would not be subtracted to arrive at FCF. Thus, using this description, discretionary cash expenditures would include growth-oriented capital expenditures and acquisitions, debt reduction, dividends, and stock repurchases.

IAS 7 implies a capital maintenance approach; that is, capital expenditures should only represent those expenditures necessary to maintain the company's operational assets. Expenditures beyond this amount should represent discretionary expenditures. To compensate for the lack of normal capital expenditure information, many analysts use total capital expenditures, thus generally understating FCF.

Some regulatory agencies use FCF as a measuring tool. These agencies use a percentage of sales or assets to represent a surrogate capital maintenance expenditure amount. The New Jersey Gaming Commission, for example, uses FCF in its financial viability analysis and defines capital maintenance as "five percent of net revenues."

FCF: Common Problem Areas

If free cash flow were accepted as equal to CFO less capital maintenance expenditures, what adjustments would have to be made to derive FCF? A comparison of two different approaches to arriving at FCF can help: Both Coca-Cola and Mandalay Resort provide FCF information in the management's discussion and analysis section of their annual reports (which can be accessed via the SEC's Edgar service,, but they calculate FCF in very different ways.

Cash Flow at Mandalay Resort

Mandalay Resort (formerly known as Circus Circus) was one of the first companies to provide free cash flow information in its 1988 annual report. Over time, however, it has changed its definition of FCF. Even today, the company has its own unique definition.

The FCF analysis of Mandalay Resort indicates that it starts with income from operations. But a comparison with the income statement reveals that, in 2000, the company added back preopening expenses and an abandonment loss. The company added back the depreciation and amortization and interest, dividends, and other income, and subtracted cash taxes paid. It also added back proceeds from the disposal of equipment and other assets. This provided a figure called "cash available for repayment of debt and reinvestment." Exhibit 2 compares the company's cash available for repayment of debt and reinvestment with its CFO. Over the past 10 years, the difference between the two measurements has steadily increased.

An analysis of Mandalay Resort's SCF shows that Mandalay Resort ignored two major items in its FCF analysis. The company's FCF analysis did not account for changes in working capital. It also substantially overstated cash flows by not including unconsolidated affiliate earnings. Interestingly, joint venture depreciation was added back to arrive at cash flow.

The company's FCF analysis identifies cash available for repayment of debt and reinvestment of $518.8 million, while its SCF shows net cash provided by operating activities of $204.9 million. Approximately half of this material difference of $314 million may be explained by the supplemental cash payments for interest expense of $170.272 million that is net of interest capitalized. Interest payments have increased substantially over the last 10 years. It also means that only $14 million of the $184.039 million payment of principal and interest represents principal.

The major problem in deriving or reconciling FCF is defining ordinary capital expenditures. Mandalay Resort has expanded significantly over the last 10 years. A comparison of ordinary capital expenditures with actual capital expenditures over the last three years found that ordinary capital expenditures represented less than 10% of total capital expenditures. Some argue that ordinary expenditures should at least equal the amount being depreciated. Mandalay Resort's estimate of ordinary capital expenditures ($43.451 million) is less than 25% of depreciation ($178.301 million).
Exhibit 3 compares Mandalay Resort's definition of ordinary capital expenditures with actual capital expenditures and capital maintenance over the last five years, based on 5% of net revenues. This shows that the company is using figures that enhance its FCF analysis.

Cash Flow at Coca-Cola

Like Mandalay Resort, Coca-Cola reports FCF information in its annual report. Coca-Cola bases their FCF analysis on CFO. Prior to 1999, Coca-Cola defined FCF as CFO less investment activities in the SCF. This approach allowed the user to easily see how the company arrived at FCF. In 1999, the company changed their definition to CFO less "business reinvestment." Further analysis of the SCF indicates that the company netted a few components of investment activity to derive this business reinvestment figure. In fact, in 1999 it included everything except acquisitions and investments. Exhibit 4 provides a comparison of business reinvestment to SCF investment activities for the three years reported in the 1999 annual report. By using business reinvestment instead of investment activities in its calculation, Coca-Cola effectively increased its reported FCF in 1998 (by over $500 million) and 1999 (by almost $2 billion).

Exhibit 5 provides a comparison of Coca-Cola's business reinvestment with actual capital expenditures (PP&E) and capital maintenance based on 5% of net revenues. Unlike Mandalay Resort, Coca-Cola's use of "business reinvestment" shows that the company is using a figure that hurts its FCF analysis.
This raises the question of what should be included in the calculation of FCF. Mandalay Resort starts with income from operations and goes through a series of additions and subtractions to arrive at FCF, some of which cannot be reconciled using information from the annual reports. On the other hand, Coca-Cola includes investments and other assets-should it have included purchases of property plant and equipment as ordinary expenditures? A review of the investing activities on the SCF would indicate that FCF varies significantly depending upon what is included.

Settling on a Definition

The SCF has been around since 1987. It is time to make use of it by pointing out to investors, creditors, and management that CFO, taken from the SCF, is a more relevant indicator of true cash flow than most of the surrogates currently in use. FCF is an important measure of a firm's financial strength. However, before FCF can represent relevant information, a consensus must be reached on what it really represents. If companies are to include FCF information in their annual reports, this information should be relevant and comparable. The IAS has developed an international description of FCF that surely could be used as a basis for greater consistency and uniformity of presentation.

The analysis above highlights the problem of using corporate-generated data outside of the audited financial statements. Companies may make adjustments to highlight a certain point of view. The two annual reports in this analysis clearly show divergent approaches toward FCF; anyone using these reports must evaluate the information provided to arrive at comparable cash flow information. Unfortunately, analysts use different terminology for cash flow and free cash flow. Until there is more consistency, one must be very careful before using comparative cash flow information from companies or analysts.

See Sidebar 1 for this article. (Cash Flow Definitions)

See Sidebar 2 for this article. (Free Cash Flow Definitions)

John Mills, PhD, CPA, is a professor and Lynn Bible, PhD, and Richard Mason, JD, are assistant professors, all at the University of Nevada, Reno.

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