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In Brief
Lack of a Consensus Calculation
It is not unusual to pick (11) an analysts' report, quarterly statement, or annual report and find references to a company's cash flow or free cash flow. But what do these terms really mean? There ar many wasy to define cash flow and free cash flow, resulting in problems of consistency and comparability. The authors use data from actual comapnies to illustrate the problems created by different calculations of cash flow. It is time to make better use of the statement of cash flows and derive a more consistent calculation of cahs flow and free cash flow.
While companies, analysts, and investors realize the importance of cash flow, there is no real consensus on the definition of cash flow or free cash flow (see the Sidebars for sample definitions). This can lead to considerable misinterpretation when investors are relying on differing cash flow information provided by companies. It is imperative to reach a consensus about the meaning of the terms cash flow and free cash flow because financial analysts routinely use such terms in their reports and companies provide their own calculations of them in the management's discussion and analysis and financial highlights sections of their annual reports.
Cash Flow
Analysts and creditors know that an accurate measurement and projection of a company's ability to generate cash is critical to gauging its debt-service capability and overall debt capacity. Prior to the 1987 issuance of SFAS 95, Statement of Cash Flows, both groups suggested adding back depreciation as a means to derive cash flows. Analysts developed a surrogate for cash flows that in its simplest form was defined as "net profit plus depreciation." Creditors, on the other hand, wanted a figure that represented cash available to meet principal and interest payments, so they devised a calculation of earnings before interest, taxes, depreciation, and amortization (EBITDA). Before SFAS 95, EBITDA was analysts' and creditors' best available surrogate for a company's cash available to meet principal and interest payments. Surrogate cash flow information is still used even though cash flow from operations is readily obtained from SFAS 95's statement of cash flows (SCF). The accounting profession should insist that disclosures in financial reports not call a measure "cash from operations" unless...