Theory of free cash flow

Also see dual cash flow.

When companies report their earnings, these earnings are reported on an "accrual" basis according to generally accepted accounting principles (GAAP). These earnings usually are not based on cash receipts. For example, a company may make a sale in December and not receive payment until January. Similarly, a company may claim a depreciation expense for production equipment, but they didn't actually have to pay out any cash for this expense. They do, however, have to make new investments in order to remain competitive, but these investments are often not completely reflected in the reported earnings.

It is quite possible for a company to report positive earnings while experiencing negative cash flows. Growing companies can experience this phenomenon, especially when they need to reinvest much of their earnings in the business in order to maintain and increase growth rates.

Companies can and do engage in earnings "smoothing" so as to make their earnings numbers look good for Wall Street. Free cash flow analysis puts all business activity back on a cash basis.

Free cash flow attempts to answer the questions:

· Where did the cash come from, and where did it go?

· How much of that cash is (or might be) available to investors (both equity holders and debt holders)?

· How much investment is required on an ongoing basis to maintain and grow these cash flows?

Sources and Uses of funds

SPREDGAR compares successive quarterly or yearly balance sheet data contained in the EDGAR "article" section to figure out which accounts changed, and by how much. In general, decreases in asset accounts represent a source of cash for the company, and increases represent uses. The opposite is true of liability and equity accounts.

In the worksheet below, the red triangles represent Excel "notes". If you move your cursor over them when in Excel, the notes will be displayed. They contain most of the same information given here. Just as in a real financial statement, the notes contain important information.

The above worksheet fragment shows sources and uses of funds. Some observations:

1. Cash has declined by $1,533 million from the previous period. This is a "source" of funds to finance other activities. (Note that for this worksheet we multiply all amounts by $1 million. SPREDGAR will automatically convert the multiplier to a common value if it changes over the period.)

2. Receivables have increased by $166 million. This represents a use of cash to the company, since outstanding receivables represent cash owed to the company but not collected.

3. Inventory has increased by $311 million. Since this cash is "tied up in inventory," it represents a use of cash.

4. Gross property, plant, and equipment (PP&E) is $286 million higher than it was in the previous period. This is a use of cash. Note that some PP&E may have been sold, but $286 million is the net difference.

5. Accounts payable have increased by $172 million. This represents cash owed and paid to suppliers. This cash is thus available for other purposes, and is a source of funds.

6. Current liabilities have decreased by $498 million. This represents cash owed and paid to suppliers. This cash is thus not available for other purposes, and is a use of funds.

7. The company issued a net $1,674 million in bonds. Other long-term liabilities have increased by $39 million. Both of these represent sources of funds.

8. Other shareholder's equity has declined by $13 million, net of expected increases due to positive net income. Therefore, the company must have repurchased $13 million in stock.

9. Net income provides a source of cash if the company showed positive net income over the period. If the company lost money, then the cash to finance the loss must have come from somewhere else.

The worksheet displayed below classifies each source and use of funds into either operating, investing, or financing categories:

Property, plant, and equipment are always investing activities, as are other long-term assets and investments. Bonds, preferred, preferred mandatory, common, and other shareholder's equity are always financing.

The one problematic area is other long-term liabilities. This includes notes payable, minority interests, deferred income taxes, and other long-term obligations. It is included as a financing cash flow since most of the changes in this category is due to changes in notes payable. However, some cash flows can be classified as operating (e.g., deferred income taxes) or Investing (e.g., minority interests). Consult the original filing to see if these are significant.

All other cash flows are classified as operating.

The sum of all of the cash flows should equal the reported change in cash on the balance sheet, according to the equation:

Operating CF + Investing CF + Financing CF = change in cash on the balance sheet.

This provides a nice check on whether or not there are problems with the filing and/or SPREDGAR.

What cash are investors entitled to?

The theory of free cash flow states that investors are entitled to the sum of the operating and investing cash flows, plus any cash interest paid. Cash interest is included because it is seen as flowing to the debt holders of the firm.

In our example, Intel is obviously required to make heavy investments in order to remain viable in the extremely competitive semiconductor business. This can be seen by the total investing cash flows of $1.5 billion for this quarter. Traditional GAAP accounting attempts to get at this phenomenon through depreciation, but depreciation often understates the true cost of replacement equipment and new investment required to maintain and/or grow the business.

In the U.S. and other countries, interest expense is tax-deductible at the corporate level. Therefore, a company generating positive cash flow has a tax advantage from this deductibility. Leveraged cash flow includes the tax benefits. Unleveraged cash flow removes this benefit. In the example above, the leverage was not significant enough to affect free cash flow per share.

Note that free cash flow per share is negative (for the Dec-2005 period, the Apr-2006, and the Mar-2007 periods), even though Intel reported positive earnings of $0.42/share, $0.23/share, and $0.28/share, respectively, for these periods. Free cash flow analysis demonstrated exactly how much of these earnings were consumed by new investment.

Gordon Gerwig, founder of Spredgar Software, has a B.S. in Electrical Engineering and Computer Science from the University of California at Berkeley and an M.B.A. in Finance from the University of California at Davis. Gordon Gerwig and Spredgar Software have been written up in Online Investing for Dummies, Online Investing Hacks, and in the Innovator, the U.C. Davis Graduate School of Management's alumni magazine. Gordon is an individual investor and a member of the American Association of Individual Investors (AAII). He is a CERTIFIED FINANCIAL PLANNER, a Licensed International Financial Analyst (LIFA) , and is an associate member of the CFA Institute. He has worked in financial services as a advisor for Morgan Stanley and American Express. He has experience in small business lending, valuation and consulting. Spredgar Software's mission is to provide unbiased financial investment data through Excel add-in software for the private investor, the professional analyst, and the academic.