Prepared by: Nir Yehuda

With contributions by

Stephen H. Penman – Columbia University

Peter D. Easton and Gregory A. Sommers - Ohio State University

Luis Palencia – University of Navarra, IESE Business School

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10-3

What you will learn from this chapterWhat 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

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10-4

The Calculation of Free Cash FlowThe Calculation of Free Cash Flow

• Three methods to calculate FCF:

1. Use the sources of cash flow equation:

that is, free cash flow is operating income adjusted for the change in net operating assets

2. 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.

3. FCF can also be obtained from the reformulated Statement of Cash Flows.

C - I = OI - ΔNOA

C - I = NFE - ΔNFO + d

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10-5

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

Method 1:

C – I = OI -

Operating income 1996 Net operating assets 1996 Net operating assets 1995 Free cash flow 1996

$ 2,659 2,208

$ 549

(451)

$98

Method 2: C – I = NFE - FO + d

Net financial expenses 1996 Net financial obligations 1996 Net financial obligations 1995 Net dividend 1996 Free cash flow 1996

$ 228

244

$ 14

16

68

$98

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10-6

Calculation of Free Cash Flow:Calculation of Free Cash Flow:Reebok, 1996Reebok, 1996

Method 1:

C – I = OI -

Operating income, 1996 Net operating assets, 1996 Net operating assets, 1995 Free cash flow, 1996

$1,135 1,220

$ 168

85

$ 253

Method 2: C – I = NFE – ΔNFO + d +MI (income) - MI (balance sheet)

Net financial expenses, 1996 Net financial obligations, 1996 Net financial obligations, 1996 Net dividend, 1996 Minority interest in income Change in minority interest in balance sheet Free cash flow, 1996

$720 287

$ (20)

(433)

693 15

(3)

253

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10-7

The Standard GAAP Statement of Cash FlowsThe Standard GAAP Statement of Cash Flows

Standard Statement of Cash Flows

“Cash Flow from Operations”

- “Cash Used in Investing Activities”

+ “Cash from Financing Activities”

= in Cash and Cash Equivalents

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10-8

Reformulated Statement of Cash FlowsReformulated Statement of Cash Flows

Cash flow from Operations

- Cash investments

=Free Cash Flow from Operating Activities

Cash Paid to Shareholders

+ Cash Paid to Debtholders and Issuers

=Cash Paid for Financing Activities

This format follows the cash conservation equation:

C – I = d + F

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10-9

Nike, Inc. Nike, Inc. GAAP Statement of GAAP Statement of

Cash FlowsCash Flows

Year ended May 1996 1995 1994 ______________________________________________________________________________________ Cash provided (used) by operations: Net income $553,190 $399,664 $298,794 Income charges (credits) not affecting cash: Depreciation 97,179 71,113 64,531 Deferred income taxes and purchased tax benefits (73,279) (24,668) (23,876) Other liabilities 465) (1,359) (3,588) Amortization and other 35,199 19,125 8,067 Changes in certain working capital components: (Increase) decrease in inventory (301,409) (69,676) 160,823 (Increase) decrease in accounts receivable (292,888) (301,648) 23,979 (Increase) decrease in other current assets (20,054) (10,276) 6,888 Increase (decrease) in accounts payable, accrued liabilities and income taxes payable 332,548 172,638 40,845

Cash provided by operations 330,021 254,913 576,463

Cash provided (used) by investing activities: Additions to property, plant and equipment (216,384) (154,125) (95,266) Disposals of property, plant and equipment 12,775 9,011 12,650 Additions to other assets (26,376) (6,260) (5,450) Acquisition of subsidiaries: Identifiable intangible assets and goodwill -- (345,901) (2,185) Net assets acquired -- (84,119) (1,367)

Cash used by investing activities (229,985) (581,394) (91,618)

Cash provided (used) by financing activities: Additions to long-term debt 5,044 2,971 6,044 Reductions in long-term debt (30,352) (39,804) (56,986) Increase (decrease) in notes payable 47,964 263,874 (2,939) Proceeds from exercise of options 21,150 6,154 4,288 Repurchase of stock (18,756) (142,919) (140,104) Dividends common and preferred (78,834) (65,418) (60,282)

Cash provided (used) by financing activities (53,784) 24,858 (249,979) Effect of exchange rate changes on cash (206) (1,122) (7,334) Net (decrease) increase in cash and equivalents 46,046 (302,745) 227,532 Cash and equivalents, beginning of year 216,071 518,816 291,284

Cash and equivalents, end of year $262,117 $216,071 $518,816

Supplemental disclosure of cash flow of information: Cash paid during the year for: Interest (net of amount capitalized) $ 32,800 $ 20,200 $ 11,300

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10-10

Problems with the Standard StatementProblems with the Standard Statement

1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section

2. Transactions in financial assets are included in the investments section rather than in the financing section

3. Cash interest is included in the operating rather than in the financing section

4. Tax cash flows are all included in the operating section, and not allocated to operating and financing

5. The statement does not incorporate non-cash transactions

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10-11

1. Operating Cash and Cash in Financial Assets: 1. Operating Cash and Cash in Financial Assets: NikeNike

Change in cash and cash equivalents $46 million

Increase in operating cash $7 millionIncrease in financial assets 39______

$46 million

The determination of operating cash: use a normal percentage of sales for the industry

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10-12

2. Transactions in Financial Assets: Lucent 2. Transactions in Financial Assets: Lucent TechnologiesTechnologies

Fiscal Year Ending September

1999 1998 1997

Net income 4,766 1,035 449 Cash from operating activities (276) 1,860 2,129 Cash in investing activities: Capital expenditures (2,215) (1,791) (1,744) Proceeds from the sale or disposal of property, plant and equipment 97 57 108 Purchases of equity investments (307) (212) (149) Sales of equity investments 156 71 12 Purchases of investment securities (450) (1,082) (483) Sales or maturity of investment securities 1,132 686 356 Dispositions of businesses 72 329 181 Acquisitions of businesses - net of cash acquired (264) (1,078) (1,584) Cash from mergers 61 - - Other investing activities - net (69) (80) (68) Net cash used in investing activities (1,787) (3,100) (3,371)

Net sales of financial assets 682 (396) (127)

Adjusted cash investment in operations 2,469 2,704 3,244

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10-13

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

Interest payments $32,800Interest income (16,000)Net interest payments

before tax (16,800)Tax benefit (at 38.5%) 6,468 $10,332

Add back to GAAP cash from operations

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10-14

5. Non-cash Transactions5. Non-cash Transactions

• Acquisitions with shares

• Asset exchanges

• Assets acquired with debt

• Capitalized leases

• Installment purchases

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10-15

The Reformulated Statement of Cash Flows: the The Reformulated Statement of Cash Flows: the AdjustmentsAdjustments

GAAP Free Cash Flow

+ Net cash interest outflow (after tax)

+ Investments in financial assets

- Sale of financial assets

- Noncash investments

- Increase in operating cash

- Investment in operating assets on installment basis

= Free Cash Flow

GAAP Financing Flow

+ Net cash interest outflow (after tax)

- Noncash financing

+ Purchase of financial assets

- Sales of financial assets

+ Increase in cash equivalents

= Financing Cash Flow

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10-16

Nike, Inc. Reformulated Statement of Cash FlowsNike, Inc. Reformulated Statement of Cash Flows

Free Cash Flow Reported cash from operations Net interest paid after tax

Cash investments reported Investment in operating cash Free cash flowFinancing Flow to ClaimantsDebt financing: Additions to long-term debt Reductions to long-term debt Increase in notes payable Net interest paid, after taxes Investments in cash equivalentsEquity financing Share issues (from exercise of options) Purchases of shares DividendsTotal financing flows

2307

(5)30

(48)1039

(21)1979

33010

340

237103

26

77103

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10-17

Why Free Cash Flow from Adjusted Cash Flow Why Free Cash Flow from Adjusted Cash Flow Statements May not Reconcile to the Methods 1 and 2Statements 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

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10-18

The Calculation of Cash Flow from OperationsThe 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 operationsR&D expendituresInvestment 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

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10-19

The Quality of the Reported Cash Flow from Operations The Quality of the Reported Cash Flow from Operations (CFO) Number as an Indicator of Profitability(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