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Senin, 02 November 2009
free cash flow: a panacea of financial analysis?
Accountancy SA, Sep 2004 by Prinsloo, Frans, Rosenberg, David
in many instances where accounting scandals have occurred; there was a mismatch between cash flow and earningsWhen evaluating a company's financial situation, care should be taken not to place reliance solely on the company's income statement figures (such as earnings per share and the growth therein), while disregarding its free cash flow figures. While the earnings history of a company may appear to be good, it is possible that negative free cash flows may create liquidity problems, which may force the company out of business. To illustrate this: In the 31 December 1999 audited group results of Leisurenet Ltd, a revenue increase of 32.7% and an increase in headline earnings per share of 24% were reported. However, upon computing Leisurenet's free cash flow for the 1999 financial year, the extent of the company's cash flow problems become apparent (a negative free cash flow of R279 million).
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A reason why free cash flow has become fashionable among analysts is the perception that the quality of reported corporate earnings figures is questionable (due to their being prone to manipulation)2. The belief is that free cash flow figures are less prone to manipulation. It has been found that in many instances where accounting scandals have occurred; there was a mismatch between cash flow and earnings. In an article appearing in Business Week3 one of the five ways identified to "avoid more Enrons" is to "provide aid in figuring free-cash flow".
Certain companies now regard the generation of free cash flow as a key objective in generating shareholder value. For example, in its 2001 annual report Cadbury Schweppes plc stated that one of the three targets against which "growth in shareholder value" is measured, is the generation of "�150 million of free cash flow every year".
What exactly are 'free cash flows'?
As there is no regulatory standard prescribing the method for computing the figure, investors disagree on exactly which items should be included in its calculation, and the method used is subjective and based on individual preferences4. The many ways of defining 'free cash flow' result in problems of consistency and comparability, and care therefore has to be exercised when using a reported free cash flow figure, without fully understanding the method of computation used.
A widely used formula5 is: Free cash flow = Net operating profit after tax any non-cash adjustments shown on the statement of cash flows (e.g., depreciation) - gross investment in operating capital (i.e., gross investment / increase in fixed operating assets and working capital).
'Free cash flow' is the cash flow actually available for distribution to the providers of finance after the company has made all investments in property, plant and equipment and working capital necessary to sustain ongoing operations. It therefore represents the cash that is available for the:
* Payment of interest and dividends;
* Repayment of debt and repurchase of shares; and
* Purchase of marketable securities and other non-operating assets.
The following diagram summarises the two methods that may be used to derive free cash flow using the figures reported in a company's financial statements:
The 'financing perspective' method is merely another method of determining free cash flow, essentially by analysing the movements in funds to providers of finance, and will yield the same answer as the Operating perspective' method.
To compute a sustainable free cash flow figure, which may be useful for financial analysis purposes, it is important that when using the Operating perspective' method to exclude the cash utilised, to expand operations from the figures for capital expenditure and working capital (using the 'financing perspective' the amount of cash utilised to expand operations must be added onto the computed free cash flow figure).
Applications
By the providers of credit
Providers of credit can use free cash flow to determine whether the company will have the cash available to meet future debt obligations. In evaluating credit strength the four major credit rating agencies evaluate how much free cash flow a company is generating6. Fitch has introduced a cash flow adequacy ratio (CFAR, pronounced 'see far') that compares a company's average net free cash flow over the past three years with its average annual principal debt maturing over the next five years. The higher the company's CFAR, the stronger its credit rating.
According to an analyst from Lehman Brothers7 "...looking at free cash flow instead of reported earnings per share is a better indicator of the kind of real value being created by the entity instead of clouding the underlying cash flow by accounting rules ... It just gives you a better idea of the underlying cash that the business is generating".
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