Prepared by: Nir Yehuda With contributions by Stephen H. Penman Columbia University Peter D. Easton and Gregory A. Som

3. 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

4. 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.

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

6. Calculation of Free Cash Flow:Reebok, 1996

7. The Standard GAAP Statement of Cash Flows

8. Reformulated Statement of Cash Flows

9. Nike, Inc. GAAP Statement of Cash Flows

10. 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

11. 1. Operating Cash and Cash in Financial Assets: Nike

12. 2. Transactions in Financial Assets: Lucent Technologies

13. 3. and 4. Net Interest Payments and Taxes on Net Interest Payments: Nike

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

15. The Reformulated Statement of Cash Flows: the Adjustments

16. Nike, Inc. Reformulated Statement of Cash Flows

17. 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

18. 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

19. 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