a free cash flow version of the cash flow statement

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Free cash floversion of caflow stateme

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Managerial Fin

Vol. 32 No. 8,

pp. 64

# Emerald Group Publishing Lim

0307

DOI 10.1108/0307435061067

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

Dimitrios V. KousenidisSchool 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 flowstatement. In specific, the paper relates the comprehensive income concept to the definition of freecash flows and shows how free cash flows and residual income can be calculated from the cash flowstatement.Design/methodology/approach This paper exhibits how this different version of the cash flowstatement can be reported by illustrating the differences with the form of the statement required bythe 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 usinga simple definition of a companys free cash flow.Practical implications The method used requires a different version of a cash flow statement inwhich all financing related cash flows, such as interest expense is not included in the cash flow fromoperating activities. This version of the cash flow statement can be used in order to evaluate andappreciate financial policy formulation.Originality/value The paper provides to the shareholders and all the parties who are interested infirm and its operation (managers, lenders etc) with information about the companys ability todistribute dividends, to issue new debt and in general the companys ability to meet its obligations.

Keywords Cash flow, Financial reporting

Paper type Research paper

1. IntroductionThe form and the information content of the cash flow statement has been a familiartopic in finance and accounting research. Billings and Morton (2002) have updated andextended the analysis on cash flows from operating activities and credit risk. Theirfindings revealed firm characteristics that relate to the cross-sectional variationbetween operating cash flow and credit risk. Jupe and Rutherford (1997) have tried toinvestigate the forms of disclosing free cash flows in published financial statements.Their results indicate that most companies publish financial and statistical data thatcan be interpreted as information that enables the calculation of free cash flows.Finally, Bahnson et al. (1996) report significant differences between expected andactual cash flows. Further, they investigate on the practical implications of thesefindings and conclude that the indirect method results in unreliable cash flow

estimations. Thus, they urge FASB members to require from companies in the USA toreport 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 fromoperating an investing activities with the free cash flows required for companyvaluation. The paper consists of four sections. Section 2 describes a cash flowstatement as amended by International Accounting Standard (IAS) No. 7 and FASBstatement No. 95. Section 3 develops a simple mathematical model that relates freecash flows with a comprehensive concept of accounting earnings and relates DCFvaluation with accounting-based valuation models. Section 4 offers a summary and

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some implications, and finally the appendix uses a numerical example to exemplify theproposed form of the cash flow statement.

2. Regulatory requirements on reporting cash flows

2.1. The International Accounting Standard No. 7IAS No. 7 has been enforced on 1 January 1994 and requires that a cash flow statementis included among a financial statements that a company should publish. The standardperceives that cash flow information is useful to investors in order to evaluate theability of a specific company to generate cash and cash equivalents. Entrepreneursarrive at beneficial economic decisions based on the evaluation of the companys abilityto produce cash and cash equivalents and on the timing and certainty of the productionof the availability of these cash flows.

The IAS requires information about past changes in the cash balance of a firm. Thestatement of cash flows can be used in order to provide information of this kind, whichin turn is used by entrepreneurs to reach beneficial decisions. The cash flow statementis classified into three sections. Each of these sections describes cash flow that

occurred with in an accounting period from different business activities andspecifically from operating activities, investing activities, and financing activities.

Cash flows from operating activities display the inflows that a company hasoccurred by executing its normal activity i.e. selling its primary products or services,during the accounting period. Cash flows from operating activities include all inflowsand 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 occurredwithin an accounting period and concern all the investments that the company hasmade. Primarily, these cash flows refer to cash received or paid for the acquisition ordisposal of long term (fixed assets).

Cash flows from financing activities include the remaining of the activities thatcannot be classified either as operating or investing. It usually includes the receiptsfrom issuing new shares, the payments to retire equity capital, the payments ofdividends to the shareholders, the receipts from issuing new debt capital such asbonds, 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 theindirect method. Under the direct method, information about the inflows and outflowsof cash can be obtained from the income statement and the balance sheet by adjustingsales and related costs to reflect cash receipts and cash payments. Under the indirectmethod, cash flow from operating activities are obtained by transforming operatingearnings or losses on a cash basis.

Cash flows from investing and financing activities should be reported separatelyfrom the cash flow from operating activities and in a unified form that does not allowthe selection between a direct or indirect method.

2.2. The FASB Statement No. 95Since 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 financialstatements that companies should publish. The new SFAS No. 95 supersedes AccountingPrinciples 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 severalproblems, which are clearly identified in SFAS No. 95, paragraph 2:

. . . Certain problems have been identified in current practice, including the ambiguity of termsuch 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 differencesin definitions of funds flow from operating activities (cash or working capital). . .

The new statement provides a clear definition of funds as being cash and short-terminvestments. Moreover, it identifies the primary purpose of the cash flow statement asproviding relevant information about the cash receipts and payments of an enterprise(paragraph 4). The Board claims that this information, if used with related disclosuresand 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 obligationsand pay dividends;

(3) the reasons for differences between net income and associated cash receipts andpayments; and

(4) the effect on the enterprises financial position of its investing and financingtransactions 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 operatingactivities;

(2) the indirect (or reconciliation) method starts with net income and makesadjustments for non-cash revenues and expenses, and for changes in non-cashcurrent 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 andlosses/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 flowsfrom operating activities must also be produced.

2.3. The form of the cash flow statementIn 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 asTreasury bills, commercial paper, and money market funds with maturity of three-month 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 Content

Operating activitiesCash inflows

Cash receipts from sales of goods andservices

Cash sales plus collections of receivables fromcustomers

Cash receipts for dividends and interest Cash receipts from returns on loans, debt, andequity instruments

Other cash receipts Other cash receipts that are not classified asinvesting or financing

Cash outflowsCash payments to suppliers Cash payments to acquire materials for

manufacture or resale plus payments onpayables to suppliers

Cash payments to employees and othersuppliers

Cash payments to employees for their services andsuppliers of goods other than materials formanufacture or resale

Cash payments to governments Cash payments of taxes, duties, fines, and other feesor penalties

Cash payments for interest Cash payments to lenders and other creditors forinterest

Investing activitiesCash inflows

Loan collections Cash receipts from collections of loans madeto other entities

Sale of investments in debt securities Cash receipts from sale of other entities debtsecurities such as bonds or notes

Sale of investments in equity securities Cash receipts from sale of other entities equitysecurities

Sales of property, plant and equipment,and other term assets

Cash receipts from sale of long-term assets otherthan long-investment securities and loans

Cash outflowsLoans to other entities Cash loans to other entitiesInvestments in debt securities Payments to acquire debt securities of other entitiesInvestments in equity securities Payments to acquire equity securities of other

entitiesAcquisition of property, plant andequipment, and other long-term assets

Payments to acquire long-term assets otherinvestments in securities and loans

Financing activitiesCash inflows

Proceeds from issuing equityinstruments

Cash receipts from issuing preferred or commonstock, stock warrants, etc.

Proceeds from issuing short-term debt Cash receipts from issuing short-term notes, loansfrom banks, etc.

Proceeds from issuing long-term debt Cash receipts from bonds mortgages, notes, bankloans

Cash outflowsPayment of dividends Cash dividends payments to preferred and common

stockholdersPurchases of treasury stock Cash payments to purchase entitys common or

preferred sharesPrincipal payments of short-term debt Cash payments to other than for interest to holders

of short-term debt(Continued)Table I.


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investing activities. For example, conversion of bonds into common stock, acquisitionof assets in exchange for common stock.

3. Free cash flows and the cash flow statementMost 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 definitionof free cash flow requires that cash flow does not incorporate any financing-relatedcash flows, such as interest expense or dividends. It simply reflects the cash flowgenerated by a company that is available to all providers of the companys capital, bothdebt and equity. In fact these definition shows that free cash flow is equal to all cashflows paid to or received from the companys capital providers and is in accordancewith a comprehensive or clean-surplus accounting income concept which requires thatall 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 aredefined as being equal to the companys net cash flow for the period plus the change inthe 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 NCCtWCtFAt 1

where, FCFt is the free cash flow of a company in period t, Et the operating earnings ofa company in period t, NCCt the non-cash charges of a company in period t, WCt thenew investment in current assets during period t, and FAt the new investment infixed assets during period t.

Assuming that the non-cash charges include the depreciation and the change inaccrual accounts during the period, then equation (1) can be simplified as follows:

FCFt EtBVCAtBVFAt 2

or equivalently,FCFt EtBVTAt 3

where,BVCAt is the change in the book value of a companys current assets in periodt, BVFAt the change in the book value of a companys fixed assets in period t, andBVTAt 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 surplusdefinition of accounting income as follows:

Et FCFtBVTAt 4

Item Content

Principal payments of long-term debt Cash payments to other than for interest to holdersof long-term debt

Other principal payments to creditorswho have extended credit

e.g. Seller-financed debt related to purchase of planassets

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


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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 modelsdeveloped 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 tcan be

obtained as follows:

MVt X1

it1

FCFi 1 ki 5

where, MVt is the market value of a company in period t, and k the weighted averagecost of capital (WACC) of the company.

By substituting equation (3) into equation (5) and rearranging terms yields theOhlson accounting based valuation model, which has the following form:

MVt BVTAtX1

it1

Ei k BVTAi1 1 ki 6

where, BVTAt is the book value of a companys total assets in period t.The term in brackets, Etk BVTAt 1 is the residual income of a company in

period twhich is calculated as the periods operating earnings less a charge for the useof invested funds. The charge is simply the companys WACC multiplied by thecompanys book value of total assets at the beginning of period t.

Equation (5) shows that the market value of a company in period tcan be calculatedas the book value of the company in the same period plus the sum of discounted futureresidual income.

Equations (1)-(5) apply equally to finite time horizons and to individual investmentprojects. In all cases the following assumptions should hold

(1) No special significance is attached to any cash balances associated with theproject. Any cash balances are part of the projects current assets. All assetsand flows are measured at their market cash value.

(2) In principle, there is no distinction between the roles played by current assetsvs 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 consistentwith the series of end-of-period assets in these categories, respectively.

(4) Implicit in this example, the projects operating flows are gross of anydepreciation 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 entityholding a claim over the investment assets. The firm is the owner of itsassets 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 aclaim against the firms assets.) Since the debt and equity holders exhaust theclaims against the post-tax flows generated by the firms assets, the periodicpost-tax flows generated by the firms assets are identical with the pre-tax cashflows received by the firms debt and equity holders.


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(6) A statement of cash flows set up on the basis of finance principles should offerdetails for the periodic identity:

Cash flow generated by firm equals operating and investing activitiesAggregatecash flow received by owners equals financing activities.

4. Concluding remarksThe present paper uses a simple definition of a companys free cash flow and shows thatthe cash flows resulting from operating and investing activities are exactly equal to thecash flows received by debt and equity holders (financing activities). This equationrequires a different version of a cash flow statement in which all financing related cashflows, 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 appreciatefinancial policy formulation. More specifically, it provides to the shareholders and allthe parties who are interested in firm and its operation (managers, lenders etc) withinformation 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 andimplications 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 fromoperations 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 ofCompanies, McKinsey & Company, Inc.

Financial Accounting Standards Board (1987), Statement of Financial Accounting StandardsNo. 95: Statement of Cash Flow, FASB, Stamford, CT.

Jupe, R.E. and Rutherford, B.A. (1997), The disclosure of free cash flow in published financialstatements: 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, Managerialand Decision Economics, Vol. 19, pp. 55-8.

Ohlson, J.A. (1991), The theory of value and earnings and an introduction to the BallBrownanalysis, Contemporary Accounting Research, Vol. 8, pp. 1-19.

Ohlson, J.A. (1995), Earnings book value and dividends in equity valuation, ContemporaryAccounting Research, Vol. 12, pp. 661-87.

Peasnell, K.V. (1982), Some formal connections between economic values and yields andaccounting 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 theInternational Accounting Standards Committee.

Negakis, C.J. (1992), Interim financial statement, unpublished PhD dissertation, Greece.


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Appendix. A numerical exampleThe comprehensive numerical example (Table AI) illustrates a potential form of the cash flowstatement, which enables a user to directly obtain free cash flows. In this version of the cashflow statement, free cash flows are calculated as cash flows from operating activities less cash

flow from investing activities.

Table AI.Comparative balancesheet as of 31 Decemberand 200Xt and 200Xt-1(in euros)

200Xt 200Xt-1

AssetsCash 576 309Temporary investments 45 30Accounts receivable 1.590 1.875Inventories 2.400 2.814

Total current assets 4.611 5.028Plant assets 9.105 8.205Accumulated depreciation (3.705) (3.105)Loans receivable 1.305 1.155

Investment in bonds 1.134 1.062Total assets 12.450 12.345

LiabilitiesNotes payable 861 606Trade accounts payable 960 1.140Other accounts payablea 486 435Salaries payable 120 60Interest payable 75 36Dividend payable 96 96Income taxes payable 204 138Other short-term borrowings 1.032 1.383

Total current liabilities 3.834 3.894

Long-term debt 1,701 2.418Other liabilities 915 960Total liabilities 6,450 7.272Stockholders equity

Common stock 396 246Retained earnings 5.763 4.827Common stock in treasury (159) 0

Total stockholders equity 6.000 5.073Total 12.450 12.345

Income statementFor the year ended 31 December 200Xt

Net sales 18.900Costs and expensesCost of products sold 12.450

Salaries expense 2.400Deprecation expense 600Other operating expenses 1.215Interest expense 360Interest income (90)

16.935Earnings before taxes 1.965Taxes on earnings 786Net earnings 1.179

(Continued)


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Corresponding authorDimitrios V. Kousenidis can be contacted at: [email protected]

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200Xt 200Xt-1

Statement of cash flows finance approachCash flow generated by enterprise

Operating activitiesCash inflows

Net sales (IS) 18.900Interest and dividends income (IS) 90

Cash outflowsCost of products sold (IS) (12.450)Salaries expense (IS) (2.400)Other operating expenses (IS) (1.215)Taxes (IS) (786)

2.139Investing activities

Changes in current assetsIncrease in cash and cash equivalent (BS) (267)Decrease in accounts receivable (BS) 285Decrease in inventories (BS) 414Increase in temporary investments (BS) (15)

Changes in fixed assetsPurchase of plant assets (BS) (900)Increase in loans to other entities (BS) (150)Increase in investment in bonds (BS) (72)

(705)1.434

Cash flow received by debt and equity holdersFinancing activitiesChanges in current liabilities

Proceeds from issuing notes payable (BS) (255)Repayment of notes payable (BS) (600)

Decrease in trade accounts payable (BS) 180Increase in other accounts payable (BS) (51)Increase in salaries payable (BS) (60)Increase in interest payable (BS) (39)Increase in income taxes payable (BS) (66)

Changes in long-term liabilitiesRepayment of long-term debt (BS) 717Repayment of other long-term liabilities (BS) 45Other short-term borrowings 351Proceeds from issuing common stock (BS) (150)Purchase of treasury stock (BS) 159

Ordinary compensation of debt and equity holdersDepreciation expenses (IS) 600

Interest expense (IS) 360

Dividends paid (SRE) 243Total received by debt and equity holders 1.434

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


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a free cash flow version of the cash flow statement

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