Financial Education

In addition to identifying sources and uses of cash, investors are interested in measuring free cash flow. This concept focuses on the cash generated from operations in excess of that needed for reinvestment. Some measures of free cash flow can be determined directly from the cash flow statement.

Free cash flow is an important concept for valuation. Analysts frequently value firms based on the present value of expected future free cash flow. If a firm is not expected to generate free cash flow in the future, it is unlikely to be valuable.

The measure of free cash flow depends on the perspective of the investor doing the measuring. Free cash flow available to the firm represents cash flow available to both debt and equity holders. Free cash flow to equity is what remains after debtholders have received their contractually obligated payments – namely interest.

Analyzing a firm’s cash position is essential to understanding its financial health. Investors need to know how the company is generating or obtaining its cash (the cash sources) and where that cash is being expended (cash uses). The cash flow statement identifies sources and uses directly within the financing and investing sections. If further detail is needed on operations, recasting that part of the statement to the direct method completes the picture.

For AT&T, a sources and uses presentation of cash flow for 2006 would look like this:

This presentation allows the analyst to see the source from which AT&T generates most of its cash: its customers. Most of its uses of cash are also for operating costs. It also deploys a large portion of its cash for capital expenditures. The company has made acquisitions using stock instead of cash, so the acquisitions do not appear on the cash flow statement. However, there is still an impact in the large increase in capital expenditures relative to prior years, as the company is now replenishing the equipment of the acquired companies as well. Note that items such as these can also be compared to the related balance sheet accounts—in this case property, plant, and equipment—as well as other assets. Capital expenditures, net of depreciation, were actually slightly negative, yet balance sheet PP&E rose to $94.5 billion from $58.7 billion during 2006 as a result of the non-cash acquisitions. Finally, another key use of cash for AT&T was to pay dividends and repurchase shares. Of course, a greater number of shares was issued as part of the acquisition, and the company took on added debt that did not flow through the cash flow statement.

the cash flow statement is most often presented using the indirect method even though many users find the direct method more informative. However, by making certain simplifying assumptions investors can convert the operating section of the cash flow statement from the indirect to the direct method format. When done properly, the the total cash from operating activities does not change. That is, the form of the statement does not alter the substance (the end result). This is best accomplished by using the working capital adjustments the firm has given in its indirect method cash flow statement. Note also that when recast into the direct method, items such as depreciation expense and gains or losses never appear. Since the calculation does not begin with net income, there is no need to adjust these noncash or nonoperating items out of the operating section.

Although the total cash flow will not change, the cash flows for each recast line are merely estimates. Actual categories of direct cash flows may differ. Furthermore, the changes working capital items reported on the balance sheet may differ from the change reported on the cash flow statement. This can occur for several reasons, including acquisitions, dispositions, non-wholly-owned subsidiaries, or exchange rate effects.

AT&T presented its operating cash flows (reproduced below) an indirect method format.

The direct method presentation attempts to mirror the income statement, but on a cash basis rather than an accrual basis. Therefore it would not start with net income, but rather from cash collected from customers. This can be estimated as sales plus the change in accounts receivable.

The second line on a direct method cash flow statement is cash paid to suppliers. This can be estimated by taking cost of goods sold from the income statement and subtracting the changes in two working capital accounts from the indirect method presentation of cash flows: inventory and accounts payable.

Other cash operating expenses can be estimated in a similar manner. In AT&T’s case, this means adjusting selling, general and administrative expense by subtracting the changes in other working capital accounts as follows: 15,511 – 30 – (18) – 1519 = 13,980 in 2006. This measure is an imprecise estimate, as it is lumping several categories together. If the company had separately disclosed, for example, wages payable, this could be used to offset SG&A while changes in rent payable could offset rent expense. Wherever the “plug” is used to fill any gaps that did not have an appropriate offset between the income and cash flow statements, the investor should be aware of the imprecision involved in the estimate.

To finish producing the direct method cash flow statement, we need to account for any cash flows related to income statement “other income and expense” items. Recall that accounting standards require separate disclosure of cash paid for interest and for taxes. AT&T provides this disclosure in Note 13 to its 10K, partially reproduced below.

The other income and expense items are interest received, equity in net income of affiliates, and other income. Since interest received and payments from affiliates are inflows, we put them at the top of our direct method presentation. The equity in net income from affiliates was not all received as a cash inflow, so only the net amount (less the cash flow statement adjustment) is recorded. The information available was sufficient to create a report that came close to the cash from operations reported indirectly, but a plug was still needed to make the statements “foot,” or agree with each other.

Given this information, it is now possible to recast the indirect method presentation of cash flow from operations into a direct method presentation as follows (italicized data represent significant assumption effects that cannot be verified from the financial statements):

When converting a cash flow statement prepared using the indirect method presentation into one using the direct method presentation, cash paid to suppliers can be estimated by taking cost of goods sold from the income statement and subtracting the changes in two working capital accounts from the indirect method presentation of cash flows: inventory and accounts payable.

AT&T’s operating expense items from the income statement are presented below.

To estimate cash paid to suppliers for 2006, we take the 27,349 cost of sales and subtract the (2,213) change in accounts payable and accrued liabilities. Since AT&T has no “inventory” per se, this is the only adjustment needed in this case. Total cash paid to suppliers is thus 27,349 – (2,213) = 29,562.

Investors can estimate the amount of cash that a company collected from its customers by adding the sales or revenue line from the income statement to the change in accounts receivable reported on an indirect-method cash flow statement. (This estimation is not necessary if the company reports cash from operations using the direct method, as the cash collections are disclosed directly in a direct method presentation.) For example, AT&T’s income statement for the years ending 31 December 2006 includes the following sales figures:

Meanwhile, its cash flow statement from operations shows:

For 2006 AT&T’s income statement (see Chapter 2) listed total operating revenues of 63,055, while the indirect method cash flow statement reveals a change in accounts receivable of 519. Since the cash flow effect is positive it means that accounts receivable decreased. In other words, the company collected total cash from its customers of $63,055 in current-period sales, plus an additional 519 by collecting more from existing accounts than it granted in new credit. The total cash collections from customers is 63,055 + 519 = 63,574.

For all three years, the cash collections from customers amount to:

At the end of the cash flow statement, after the three main categories of cash activities, both IAS and U.S. GAAP require companies to show the net change in cash holdings for the year and reconcile that figure with the beginning and ending cash balances. Multinational firms must include exchange rate effects based on the rates used to translate items on the balance sheets. For example, Canada’s Quebecor Media, Inc. presented the following reconciliation in their cash flow statement for the years ended 31 December 2006:

AT&T lists several adjustments related to discontinued operations on its cash flow statements. These cash flows would have been classified as operating cash flows if the company were still in the relevant lines of business. Since the company is no longer in those businesses it segregates the cash flows into their relevant categories and reports the necessary reconciliation at the bottom of the statement of cash flows.