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A free cash flow version of the cash flow statement: a note

Dimitrios V. Kousenidis
School of Economics, Department of Business Administration, Aristotle University of Thessaloniki, Greece
Abstract
Purpose This paper reports an attempt to design a free cash flow version of the cash flow statement. In specific, the paper relates the comprehensive income concept to the definition of free cash flows and shows how free cash flows and residual income can be calculated from the cash flow statement. Design/methodology/approach This paper exhibits how this different version of the cash flow statement can be reported by illustrating the differences with the form of the statement required by the regulatory accounting bodies. Findings This paper shows that the cash flows resulting from operating and investing activities are exactly equal to the cash flows received by debt and equity holders (financing activities) by using a simple definition of a companys free cash flow. Practical implications The method used requires a different version of a cash flow statement in which all financing related cash flows, such as interest expense is not included in the cash flow from operating activities. This version of the cash flow statement can be used in order to evaluate and appreciate financial policy formulation. Originality/value The paper provides to the shareholders and all the parties who are interested in firm and its operation (managers, lenders etc) with information about the companys ability to distribute dividends, to issue new debt and in general the companys ability to meet its obligations. Keywords Cash flow, Financial reporting Paper type Research paper

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1. Introduction The form and the information content of the cash flow statement has been a familiar topic in finance and accounting research. Billings and Morton (2002) have updated and extended the analysis on cash flows from operating activities and credit risk. Their findings revealed firm characteristics that relate to the cross-sectional variation between operating cash flow and credit risk. Jupe and Rutherford (1997) have tried to investigate the forms of disclosing free cash flows in published financial statements. Their results indicate that most companies publish financial and statistical data that can be interpreted as information that enables the calculation of free cash flows. Finally, Bahnson et al. (1996) report significant differences between expected and actual cash flows. Further, they investigate on the practical implications of these findings and conclude that the indirect method results in unreliable cash flow estimations. Thus, they urge FASB members to require from companies in the USA to report cash flows from operating activities using the direct method. This note describes the form of the cash flow statement as enforced by accounting regulatory bodies and proposes some alterations that enable to relate cash flows from operating an investing activities with the free cash flows required for company valuation. The paper consists of four sections. Section 2 describes a cash flow statement as amended by International Accounting Standard (IAS) No. 7 and FASB statement No. 95. Section 3 develops a simple mathematical model that relates free cash flows with a comprehensive concept of accounting earnings and relates DCF valuation with accounting-based valuation models. Section 4 offers a summary and

Managerial Finance Vol. 32 No. 8, 2006 pp. 645-653 # Emerald Group Publishing Limited 0307-4358 DOI 10.1108/03074350610676741

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some implications, and finally the appendix uses a numerical example to exemplify the proposed form of the cash flow statement. 2. Regulatory requirements on reporting cash flows 2.1. The International Accounting Standard No. 7 IAS No. 7 has been enforced on 1 January 1994 and requires that a cash flow statement is included among a financial statements that a company should publish. The standard perceives that cash flow information is useful to investors in order to evaluate the ability of a specific company to generate cash and cash equivalents. Entrepreneurs arrive at beneficial economic decisions based on the evaluation of the companys ability to produce cash and cash equivalents and on the timing and certainty of the production of the availability of these cash flows. The IAS requires information about past changes in the cash balance of a firm. The statement of cash flows can be used in order to provide information of this kind, which in turn is used by entrepreneurs to reach beneficial decisions. The cash flow statement is classified into three sections. Each of these sections describes cash flow that occurred with in an accounting period from different business activities and specifically from operating activities, investing activities, and financing activities. Cash flows from operating activities display the inflows that a company has occurred by executing its normal activity i.e. selling its primary products or services, during the accounting period. Cash flows from operating activities include all inflows and outflows that cannot be classified as flows from investing or financing activities. Examples are the cash receipts from the sale of products or services, interest received, interest paid, and the payment of taxes. Cash flows from investing activities represent inflows and outflows that occurred within an accounting period and concern all the investments that the company has made. Primarily, these cash flows refer to cash received or paid for the acquisition or disposal of long term (fixed assets). Cash flows from financing activities include the remaining of the activities that cannot be classified either as operating or investing. It usually includes the receipts from issuing new shares, the payments to retire equity capital, the payments of dividends to the shareholders, the receipts from issuing new debt capital such as bonds, notes, and mortgages, and the payments made to retire old debt capital. Cash flows from operating activities can be reported using either the direct or the indirect method. Under the direct method, information about the inflows and outflows of cash can be obtained from the income statement and the balance sheet by adjusting sales and related costs to reflect cash receipts and cash payments. Under the indirect method, cash flow from operating activities are obtained by transforming operating earnings or losses on a cash basis. Cash flows from investing and financing activities should be reported separately from the cash flow from operating activities and in a unified form that does not allow the selection between a direct or indirect method. 2.2. The FASB Statement No. 95 Since 1988, after the release of Financial Accounting Standards Board (1987) Statement No. 95, Statement of Cash Flows, the cash flow statement became part of a full set of financial statements that companies should publish. The new SFAS No. 95 supersedes Accounting Principles Board Opinion No. 19, Reporting changes in financial position (issued in 1971), which offered companies the freedom to select both the form and the substance of the

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statement by defining fund flows according to their needs. This, however, caused several problems, which are clearly identified in SFAS No. 95, paragraph 2:
. . . Certain problems have been identified in current practice, including the ambiguity of term such as funds, lack of comparability arising from diversity in the focus of the statement (cash, cash and short-term investments, quick assets, or working capital) and resulting differences in definitions of funds flow from operating activities (cash or working capital). . .

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The new statement provides a clear definition of funds as being cash and short-term investments. Moreover, it identifies the primary purpose of the cash flow statement as providing relevant information about the cash receipts and payments of an enterprise (paragraph 4). The Board claims that this information, if used with related disclosures and information in the other statements should help users to assess (paragraph 5): (1) the enterprises ability to generate future cash flows; (2) the enterprises needs for external financing, its ability to meet its obligations and pay dividends; (3) the reasons for differences between net income and associated cash receipts and payments; and (4) the effect on the enterprises financial position of its investing and financing transactions during the period. FASB 95 recognizes two alternative ways of reporting the statement of cash flows: (1) the direct method lists cash collections and cash payments involving operating activities; (2) the indirect (or reconciliation) method starts with net income and makes adjustments for non-cash revenues and expenses, and for changes in non-cash current assets and current liabilities other than short-term financing. The adjustments to net income include: (1) non-cash expenses; (2) reclassifications such as losses/gains from the sale of long-term assets and losses/gains from retiring debt; (3) accrual-to-cash adjustments; (4) equity earnings or losses. If the direct method is used, then a schedule reconciling net income to net cash flows from operating activities must also be produced. 2.3. The form of the cash flow statement In general, the statement of cash flows has the form as shown in Table I. Cash cash and cash equivalents where cash equivalents is defined as short-term marketable securities such as Treasury bills, commercial paper, and money market funds with maturity of threemonth or less, and high liquidity. Certain non-cash transactions should be disclosed in a separate schedule (supplemental disclosure). These non-cash transactions involve financing and

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Item Operating activities Cash inflows Cash receipts from sales of goods and services Cash receipts for dividends and interest Other cash receipts Cash outflows Cash payments to suppliers Cash payments to employees and other suppliers Cash payments to governments Cash payments for interest Investing activities Cash inflows Loan collections Sale of investments in debt securities Sale of investments in equity securities Sales of property, plant and equipment, and other term assets Cash outflows Loans to other entities Investments in debt securities Investments in equity securities Acquisition of property, plant and equipment, and other long-term assets Financing activities Cash inflows Proceeds from issuing equity instruments Proceeds from issuing short-term debt Proceeds from issuing long-term debt Cash outflows Payment of dividends Purchases of treasury stock Principal payments of short-term debt

Content

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Cash sales plus collections of receivables from customers Cash receipts from returns on loans, debt, and equity instruments Other cash receipts that are not classified as investing or financing Cash payments to acquire materials for manufacture or resale plus payments on payables to suppliers Cash payments to employees for their services and suppliers of goods other than materials for manufacture or resale Cash payments of taxes, duties, fines, and other fees or penalties Cash payments to lenders and other creditors for interest

Cash receipts from collections of loans made to other entities Cash receipts from sale of other entities debt securities such as bonds or notes Cash receipts from sale of other entities equity securities Cash receipts from sale of long-term assets other than long-investment securities and loans Cash loans to other entities Payments to acquire debt securities of other entities Payments to acquire equity securities of other entities Payments to acquire long-term assets other investments in securities and loans

Cash receipts from issuing preferred or common stock, stock warrants, etc. Cash receipts from issuing short-term notes, loans from banks, etc. Cash receipts from bonds mortgages, notes, bank loans Cash dividends payments to preferred and common stockholders Cash payments to purchase entitys common or preferred shares Cash payments to other than for interest to holders of short-term debt (Continued)

Table I.

Item Principal payments of long-term debt Other principal payments to creditors who have extended credit

Content Cash payments to other than for interest to holders of long-term debt e.g. Seller-financed debt related to purchase of plan assets

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Table I.

Notes: The difference in treatment of dividends and interest is based on the concept the dividends are distribution of income while the interest cost of borrowed funds is a determinant of income

investing activities. For example, conversion of bonds into common stock, acquisition of assets in exchange for common stock. 3. Free cash flows and the cash flow statement Most finance text books define free cash flow as equal to the after tax operating earnings of a company plus non-cash charges less investment in working capital, property, plant and equipment, and other assets (Copeland et al., 1991). This definition of free cash flow requires that cash flow does not incorporate any financing-related cash flows, such as interest expense or dividends. It simply reflects the cash flow generated by a company that is available to all providers of the companys capital, both debt and equity. In fact these definition shows that free cash flow is equal to all cash flows paid to or received from the companys capital providers and is in accordance with a comprehensive or clean-surplus accounting income concept which requires that all changes in the balance sheet flow through the income statement (Kousenidis et al., 1998). Under this assumption the operating earnings of a company in period t are defined as being equal to the companys net cash flow for the period plus the change in the net book value of the companys assets during the period. In algebraic terms the definition of free cash flow can be expressed as follows: FCFt Et NCCt WCt FAt 1

where, FCFt is the free cash flow of a company in period t, Et the operating earnings of a company in period t, NCCt the non-cash charges of a company in period t, WCt the new investment in current assets during period t, and FAt the new investment in fixed assets during period t. Assuming that the non-cash charges include the depreciation and the change in accrual accounts during the period, then equation (1) can be simplified as follows: FCFt Et BVCAt BVFAt or equivalently, FCFt Et BVTAt 3 where, BVCAt is the change in the book value of a companys current assets in period t, BVFAt the change in the book value of a companys fixed assets in period t, and BVTAt the change in the book value of a companys total assets in period t. Equation (3) can be rearranged to yield the comprehensive or clean surplus definition of accounting income as follows: Et FCFt BVTAt 4 2

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Equation (1) consists of the basis for all discounted cash flow (DCF) valuation models, whilst equation (4) is the starting point for the accounting-based valuation models developed by Kay (1976), Peasnell (1982) and later by Ohlson (1991, 1995). In particular, using a DCF framework, the value of a company in any period t can be obtained as follows: MVt
1 X it1

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FCFi 1 ki

where, MVt is the market value of a company in period t, and k the weighted average cost of capital (WACC) of the company. By substituting equation (3) into equation (5) and rearranging terms yields the Ohlson accounting based valuation model, which has the following form: MVt BVTAt
1 X it1

Ei k BVTAi1 1 ki

where, BVTAt is the book value of a companys total assets in period t. The term in brackets, Et k BVTAt 1 is the residual income of a company in period t which is calculated as the periods operating earnings less a charge for the use of invested funds. The charge is simply the companys WACC multiplied by the companys book value of total assets at the beginning of period t. Equation (5) shows that the market value of a company in period t can be calculated as the book value of the company in the same period plus the sum of discounted future residual income. Equations (1)-(5) apply equally to finite time horizons and to individual investment projects. In all cases the following assumptions should hold (1) No special significance is attached to any cash balances associated with the project. Any cash balances are part of the projects current assets. All assets and flows are measured at their market cash value. (2) In principle, there is no distinction between the roles played by current assets vs fixed assets the acquisition of an asset of either category is an investment. (Note again, current assets include cash.) (3) The series of incremental investments in current and fixed assets is consistent with the series of end-of-period assets in these categories, respectively. (4) Implicit in this example, the projects operating flows are gross of any depreciation and interest expenses, but net of taxes. The firms debt and equity holders are the joint beneficiaries of its cash flows. (5) Periodic cash inflows and outflows are recorded in reference to the entity holding a claim over the investment assets. The firm is the owner of its assets debt and equity holders are the owners of the firm liability claims. (The tax authorities are usually not treated as owners even though they hold a claim against the firms assets.) Since the debt and equity holders exhaust the claims against the post-tax flows generated by the firms assets, the periodic post-tax flows generated by the firms assets are identical with the pre-tax cash flows received by the firms debt and equity holders.

(6) A statement of cash flows set up on the basis of finance principles should offer details for the periodic identity: Cash flow generated by firm equals operating and investing activities Aggregate cash flow received by owners equals financing activities. 4. Concluding remarks The present paper uses a simple definition of a companys free cash flow and shows that the cash flows resulting from operating and investing activities are exactly equal to the cash flows received by debt and equity holders (financing activities). This equation requires a different version of a cash flow statement in which all financing related cash flows, such as interest expense is not included in the cash flow from operating activities. This version of the cash flow statement can be used in order to evaluate and appreciate financial policy formulation. More specifically, it provides to the shareholders and all the parties who are interested in firm and its operation (managers, lenders etc) with information about the companys ability to distribute dividends, to issue new debt and in general the companys ability to meet its obligations.
References Bahnson, P.R., Miller, P.B.W. and Budge, B.P. (1996), Nonarticulation in cash flow statements and implications for education, research and practice, Accounting Horizons, Vol. 10 No. 4, pp. 1-15. Billings, B.K. and Morton, R.M. (2002), The relation between SFAS No. 95 cash flows from operations and credit risk, Journal of Business Finance and Accounting, Vol. 29 No. 5/6, pp. 306-68. Copeland, T., Koller, T. and Murrin, J. (1991), Valuation: Measuring and Managing the Value of Companies, McKinsey & Company, Inc. Financial Accounting Standards Board (1987), Statement of Financial Accounting Standards No. 95: Statement of Cash Flow, FASB, Stamford, CT. Jupe, R.E. and Rutherford, B.A. (1997), The disclosure of free cash flow in published financial statements: a research note, British Accounting Review, Vol. 29, pp. 231-43. Kay, J.A. (1976), Accountants too could be happy in a golden age: the accountants rate of profit and the internal rate of return, Oxford Economic Papers, New Series, Vol. 28, pp. 447-60. Kousenidis, D.V., Negakis, C.I. and Floropulos, I.N. (1998), Analysis of divisional profitability using the residual income profile: a note on cash flows and rates of growth, Managerial and Decision Economics, Vol. 19, pp. 55-8. Ohlson, J.A. (1991), The theory of value and earnings and an introduction to the BallBrown analysis, Contemporary Accounting Research, Vol. 8, pp. 1-19. Ohlson, J.A. (1995), Earnings book value and dividends in equity valuation, Contemporary Accounting Research, Vol. 12, pp. 661-87. Peasnell, K.V. (1982), Some formal connections between economic values and yields and accounting numbers, Journal of Business Finance and Accounting, Vol. 9 No. 3, pp. 361-81. Further reading International Accounting Standard No. 7 (1998), Cash Flow Statements, S.O.E. as a Member of the International Accounting Standards Committee. Negakis, C.J. (1992), Interim financial statement, unpublished PhD dissertation, Greece.

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Appendix. A numerical example The comprehensive numerical example (Table AI) illustrates a potential form of the cash flow statement, which enables a user to directly obtain free cash flows. In this version of the cash flow statement, free cash flows are calculated as cash flows from operating activities less cash flow from investing activities.
200Xt Assets Cash Temporary investments Accounts receivable Inventories Total current assets Plant assets Accumulated depreciation Loans receivable Investment in bonds Total assets Liabilities Notes payable Trade accounts payable Other accounts payablea Salaries payable Interest payable Dividend payable Income taxes payable Other short-term borrowings Total current liabilities Long-term debt Other liabilities Total liabilities Stockholders equity Common stock Retained earnings Common stock in treasury Total stockholders equity Total Income statement For the year ended 31 December 200Xt Net sales Costs and expenses Cost of products sold Salaries expense Deprecation expense Other operating expenses Interest expense Interest income 200Xt-1

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576 45 1.590 2.400 4.611 9.105 (3.705) 1.305 1.134 12.450 861 960 486 120 75 96 204 1.032 3.834 1,701 915 6,450 396 5.763 (159) 6.000 12.450

309 30 1.875 2.814 5.028 8.205 (3.105) 1.155 1.062 12.345 606 1.140 435 60 36 96 138 1.383 3.894 2.418 960 7.272 246 4.827 0 5.073 12.345

18.900 12.450 2.400 600 1.215 360 (90) 16.935 1.965 786 1.179 (Continued)

Table AI. Comparative balance sheet as of 31 December and 200Xt and 200Xt-1 (in euros)

Earnings before taxes Taxes on earnings Net earnings

200Xt Statement of cash flows finance approach Cash flow generated by enterprise Operating activities Cash inflows Net sales (IS) Interest and dividends income (IS) Cash outflows Cost of products sold (IS) Salaries expense (IS) Other operating expenses (IS) Taxes (IS) Investing activities Changes in current assets Increase in cash and cash equivalent (BS) Decrease in accounts receivable (BS) Decrease in inventories (BS) Increase in temporary investments (BS) Changes in fixed assets Purchase of plant assets (BS) Increase in loans to other entities (BS) Increase in investment in bonds (BS) Cash flow received by debt and equity holders Financing activities Changes in current liabilities Proceeds from issuing notes payable (BS) Repayment of notes payable (BS) Decrease in trade accounts payable (BS) Increase in other accounts payable (BS) Increase in salaries payable (BS) Increase in interest payable (BS) Increase in income taxes payable (BS) Changes in long-term liabilities Repayment of long-term debt (BS) Repayment of other long-term liabilities (BS) Other short-term borrowings Proceeds from issuing common stock (BS) Purchase of treasury stock (BS) Ordinary compensation of debt and equity holders Depreciation expenses (IS) Interest expense (IS) Dividends paid (SRE) Total received by debt and equity holders

200Xt-1

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18.900 90 (12.450) (2.400) (1.215) (786) 2.139 (267) 285 414 (15) (900) (150) (72) (705) 1.434

(255) (600) 180 (51) (60) (39) (66) 717 45 351 (150) 159 600 360 243 1.434

Note: aamounts owed to suppliers other than suppliers of materials for manufacture or resale

Table AI.

Corresponding author Dimitrios V. Kousenidis can be contacted at: dkous@econ.auth.gr To purchase reprints of this article please e-mail: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints

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