JWPR026-Fabozzi c53 June 24, 2008 21:55

CHAPTER 53

Cash-Flow Analysis
PAMELA P. DRAKE, PhD, CFA
J. Gray Ferguson Professor of Finance and Department Head of Finance and Business Law, James Madison University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Difficulties with Measuring Cash Flow 569 Usefulness of Cash Flows in Financial Analysis 575
Cash Flows and the Statement of Cash Flows 570 Ratio Analysis 576
Free Cash Flow 572 Using Cash-Flow Information 577
Calculating Free Cash Flow 574 Summary 578
Net Free Cash Flow 574 References 578

Abstract: An objective of financial analysis is to assess a companys operating perfor-

mance and financial condition. The information that is available for analysis includes
economic, market, and financial information. But some of the most important financial
data are provided by the company in its annual and quarterly financial statements.
These choices make it quite difficult to compare financial performance and condition
across companies, and also provide an opportunity for the management of financial
numbers through judicious choice of accounting methods. Cash flows provide a way
of transforming net income based on an accrual system to a more comparable basis.
Additionally, cash flows are essential ingredients in valuation: The value of a company
today is the present value of its expected future cash flows. Therefore, understand-
ing past and current cash flows may help in forecasting future cash flows and, hence,
determine the value of the company. Moreover, understanding cash flow allows the
assessment of the ability of a firm to maintain current dividends and its current capital
expenditure policy without relying on external financing.

Keywords: cash-flow analysis, working capital concept, cash concept, direct method,
indirect method, free cash flow, net free cash flow (NFCF), cash-flow
interest coverage ratio, cash flow-to-capital expenditures ratio, capital
expenditures coverage ratio, cash flow-to-debt ratio

One of the key financial measures that an analyst should
understand is the companys cash flow. This is because the
cash flow aids the analyst in assessing the ability of the
company to satisfy its contractual obligations and main-
tain current dividends and current capital expenditure
policy without relying on external financing. Moreover,
an analyst must understand why this measure is impor-
tant for external parties, specifically stock analysts cov-
ering the company. The reason is that the basic valua-
tion principle followed by stock analysts is that the value
of a company today is the present value of its expected
future cash flows. In this chapter, we discuss cash flow
analysis.
DIFFICULTIES WITH MEASURING
CASH FLOW
The primary difficulty with measuring a cash flow is that
it is a flow: Cash flows into the company (cash inflows)
and cash flows out of the company (cash outflows). At
any point in time there is a stock of cash on hand, but the
stock of cash on hand varies among companies because
of the size of the company, the cash demands of the busi-
ness, and a companys management of working capital.
So what is cash flow? Is it the total amount of cash flowing
into the company during a period? Is it the total amount
of cash flowing out of the company during a period? Is it

569
JWPR026-Fabozzi c53 June 24, 2008 21:55
570 Cash-Flow Analysis
the net of the cash inflows and outflows for a period?
Well, there is no specific definition of cash flowand
thats probably why there is so much confusion regard-
ing the measurement of cash flow. Ideally, a measure of
the companys operating performance that is comparable
among companies is neededsomething other than net
income.
A simple, yet crude method of calculating cash flow re-
quires simply adding noncash expenses (e.g., depreciation
and amortization) to the reported net income amount to
arrive at cash flow. For example, the estimated cash flow
for Procter & Gamble (P&G) for 2002, is:
Estimated cash flow
= Net income + Depreciation and amortization
= $4,352 million + 1,693 million
= $6,045 million
This amount is not really a cash flow, but simply earn-
ings before depreciation and amortization. Is this a cash
flow that stock analysts should use in valuing a company?
Though not a cash flow, this estimated cash flow does al-
low a quick comparison of income across firms that may
use different depreciation methods and depreciable lives.
(As an example of the use of this estimate of cash flow,
The Value Line Investment Survey, published by Value Line,
Inc., reports a cash flow per share amount, calculated as
reported earnings plus depreciation, minus any preferred
dividends, stated per share of common stock.) [Guide to
Using the Value Line Investment Survey (New York: Value
Line, Inc.), p. 19.]
The problem with this measure is that it ignores the
many other sources and uses of cash during the period.
Consider the sale of goods for credit. This transaction gen-
erates sales for the period. Sales and the accompanying
cost of goods sold are reflected in the periods net income
and the estimated cash flow amount. However, until the
account receivable is collected, there is no cash from this
transaction. If collection does not occur until the next pe-
riod, there is a misalignment of the income and cash flow
arising from this transaction. Therefore, the simple esti-
mated cash flow ignores some cash flows that, for many
companies, are significant.
Another estimate of cash flow that is simple to calculate
is earnings before interest, taxes, depreciation, and amor-
tization (EBITDA). However, this measure suffers from
the same accrual-accounting bias as the previous mea-
sure, which may result in the omission of significant cash
flows. Additionally, EBITDA does not consider interest
and taxes, which may also be substantial cash outflows
for some companies. (For a more detailed discussion of
the EBITDA measure, see Eastman [1997].)
These two rough estimates of cash flows are used in
practice not only for their simplicity, but because they ex-
perienced widespread use prior to the disclosure of more
detailed information in the statement of cash flows. Cur-
rently, the measures of cash flow are wide ranging, in-
cluding the simplistic cash flow measures, measures de-
veloped from the statement of cash flows, and measures
that seek to capture the theoretical concept of free cash
flow.
CASH FLOWS AND THE
STATEMENT OF CASH FLOWS
Prior to the adoption of the statement of cash flows, the in-
formation regarding cash flows was quite limited. The first
statement that addressed the issue of cash flows was the
statement of financial position, which was required start-
ing in 1971 (APB Opinion No. 19, Reporting Changes in
Financial Position). This statement was quite limited, re-
quiring an analysis of the sources and uses of funds in a
variety of formats. In its earlier years of adoption, most
companies provided this information using what is re-
ferred to as the working capital concepta presentation of
working capital provided and applied during the period.
Over time, many companies began presenting this infor-
mation using the cash concept, which is a most detailed
presentation of the cash flows provided by operations,
investing, and financing activities.
Consistent with the cash concept format of the funds
flow statement, the statement of cash flows is now a re-
quired financial statement. The requirement that compa-
nies provide a statement of cash flows applies to fiscal
years after 1987 (Statement of Financial Accounting Stan-
dards No. 95, Statement of Cash Flows). This statement
requires the company to classify cash flows into three cat-
egories, based on the activity: operating, investing, and
financing. Cash flows are summarized by activity and
within activity by type (e.g., asset dispositions are re-
ported separately from asset acquisitions).
The reporting company may report the cash flows from
operating activities on the statement of cash flows us-
ing either the direct methodreporting all cash inflows
and outflowsor the indirect methodstarting with net in-
come and making adjustments for depreciation and other
noncash expenses and for changes in working capital ac-
counts. Though the direct method is recommended, it is
also the most burdensome for the reporting company to
prepare. Most companies report cash flows from opera-
tions using the indirect method. The indirect method has
the advantage of providing the financial statement user
with a reconciliation of the companys net income with
the change in cash. The indirect method produces a cash
flow from operations that is similar to the estimated cash
flow measure discussed previously, yet it encompasses the
changes in working capital accounts that the simple mea-
sure does not. For example, Procter & Gambles cash flow
from operating activities (taken from their 2002 statement
of cash flows) is $7,742 million, which is over $1 billion
more than the cash flow that we estimated earlier. (Proc-
ter & Gambles fiscal year ends June 30, 2002.)
The classification of cash flows into the three types of
activities provides useful information that can be used
by an analyst to see, for example, whether the company is
generating sufficient cash flows from operations to sustain
its current rate of growth. However, the classification of
particular items is not necessarily as useful as it could be.
Consider some of the classifications:
r Cash flows related to interest expense are classified in
operations, though they are clearly financing cash flows.
JWPR026-Fabozzi c53 June 24, 2008 21:55

MATHEMATICAL TOOLS AND TECHNIQUES FOR FINANCIAL MODELING AND ANALYSIS 571

Table 53.1 Adjusted Cash Flow for P&G (2002) more reliance on cash flow from financing as can be seen
in Table 53.2.
As As Looking at the relation among the three cash flows in
(In Millions) Reported Adjusted
the statement provides a sense of the activities of the com-
Cash flow from operations $7,741 $8,134 pany. A young, fast-growing company may have negative
Cash flow for investing activities (6,835) (6,835) cash flows from operations, yet positive cash flows from
Cash flow from (for) financing activities 197 (195) financing activities (that is, operations may be financed in
Source: Procter & Gamble 2002 Annual Report. large part with external financing). As a company grows,
it may rely to a lesser extent on external financing. The
typical, mature company generates cash from operations
and reinvests part or all of it back into the company. There-
Table 53.2 Adjusted Cash Flow, Amazon.com (2001)
fore, cash flow related to operations is positive (that is a
As As source of cash) and cash flow related to investing activ-
(In Millions) Reported Adjusted ities is negative (that is, a use of cash). As a company
matures, it may seek less financing externally and may
Cash flow from operations $(120) $(30)
even use cash to reduce its reliance on external financing
Cash flow for investing activities (253) (253)
Cash flow from financing activities (107) 17
(e.g., repay debts). We can classify companies on the basis
of the pattern of their sources of cash flows, as shown in
The adjustment is based on interest expense of $139 million, and Table 53.3. Though additional information is required to
a tax rate of 35%. assess a companys financial performance and condition,
Source: Amazon.com 200110-K.
examination of the sources of cash flows, especially over
time, gives us a general idea of the companys operations.
r Income taxes are classified as operating cash flows, P&Gs cash flow pattern is consistent with that of a mature
company, whereas Amazon.coms cash flows are consis-
though taxes are affected by financing (e.g., deduction
tent with those of a fast-growing company that is reliant
for interest expense paid on debt) and investment ac-
on outside funds for growth.
tivities (e.g., the reduction of taxes from tax credits on
Fridson (1995) suggests reformatting the statement of
investment activities).
r Interest income and dividends received are classified as cash flows as shown in Table 53.4. From the basic cash flow,
the nondiscretionary cash needs are subtracted resulting
operating cash flows, though these flows are a result of
in a cash flow referred to as discretionary cash flow. By
investment activities.
restructuring the statement of cash flows in this way, it
Whether these items have a significant effect on the can be seen how much flexibility the company has when it
analysis depends on the particular companys situation. must make business decisions that may adversely impact
Procter & Gamble, for example, has very little interest the long-run financial health of the enterprise.
and dividend income, and its interest expense of $603 For example, consider a company with a basic cash flow
million is not large relative to its earnings before in- of $800 million and operating cash flow of $500 million.
terest and taxes ($6,986 million). Table 53.1 shows that Suppose that this company pays dividends of $130 million
by adjusting P&Gs cash flows for the interest expense and that its capital expenditure is $300 million. Then the
only (and related taxes) changes the complexion of its discretionary cash flow for this company is $200 million
cash flows slightly to reflect greater cash-flow generation found by subtracting the $300 million capital expendi-
from operations and less cash flow reliance on financing ture from the operating cash flow of $500 million. This
activities. means that even after maintaining a dividend payment
The adjustment is for $603 million of interest and other of $130 million, its cash flow is positive. Notice that as-
financing costs, less its tax shield (the amount that the tax set sales and other investing activity are not needed to
bill is reduced by the interest deduction) of $211 (estimated generate cash to meet the dividend payments because in
from the average tax rate of 35% of $603): adjustment = Table 53.4 these items are subtracted after accounting for
$603 (1 0.35) = $392. the dividend payments. In fact, if this company planned
For other companies, however, this adjustment may pro- to increase its capital expenditures, the format in Table
vide a less flattering view of cash flows. Consider Ama- 53.4 can be used to assess how much that expansion can
zon.coms fiscal year results. Interest expense to financing, be before affecting dividends and/or increasing financing
along with their respective estimated tax effects, results in needs.

Table 53.3 Patterns of Sources of Cash Flows

Financing Growth Financing Temporary

Externally and Growth Financial Financial
Cash Flow Internally Internally Mature Downturn Distress Downsizing
Operations + + + +
Investing activities + +
Financing activities + + or +
JWPR026-Fabozzi c53 June 24, 2008 21:55

572 Cash-Flow Analysis

Table 53.4 Suggested Reformatting of Cash Flow Statement to We get additional information by looking at the cash
Analyze a Companys Flexibility flows and their sources, as graphed in Figure 53.2. We see
that the growth in Wal-Mart was supported both by inter-
Basic cash flow
nally generated funds and, to a lesser extent, through ex-
Less: Increase in adjusted working capital
ternal financing. Wal-Marts pattern of cash flows suggests
Operating cash flow that Wal-Mart is a mature company that has become less
Less: Capital expenditures reliant on external financing, funding most of its growth
Discretionary cash flow in recent years (with the exception of 1999) with internally
Less: Dividends generated funds.
Less: Asset sales and other investing activities
Cash flow before financing
Less: Net (increase) in long-term debt
Less: Net (increase) in notes payable FREE CASH FLOW
Less: Net purchase of companys common stock Cash flows without any adjustment may be misleading
Less: Miscellaneous because they do not reflect the cash outflows that are nec-
Cash flow essary for the future existence of a firm. An alternative
measure, free cash flow, was developed by Jensen (1986)
Notes:
1. The basic cash flow includes net earnings, depreciation, and
in his theoretical analysis of agency costs and corporate
deferred income taxes, less items in net income not providing takeovers. In theory, free cash flow is the cash flow left
cash. over after the company funds all positive net present value
2. The increase in adjusted working capital excludes cash and projects. Positive net present value projects are those cap-
payables. ital investment projects for which the present value of
Source: This format was suggested by Fridson (1995). expected future cash flows exceeds the present value of
project outlays, all discounted at the cost of capital. (The
Though we can classify a company based on the sources cost of capital is the cost to the company of funds from
and uses of cash flows, more data is needed to put creditors and shareholders. The cost of capital is basically
this information in perspective. What is the trend in the a hurdle: If a project returns more than its cost of capital, it
sources and uses of cash flows? What market, industry, or is a profitable project.) In other words, free cash flow is the
company-specific events affect the companys cash flows? cash flow of the firm, less capital expenditures necessary
How does the company being analyzed compare with to stay in business (that is, replacing facilities as necessary)
other companies in the same industry in terms of the and grow at the expected rate (which requires increases in
sources and uses of funds? working capital).
Lets take a closer look at the incremental information The theory of free cash flow was developed by Jensen
provided by cash flows. Consider Wal-Mart Stores, Inc., to explain behaviors of companies that could not be ex-
which had growing sales and net income from 1990 to plained by existing economic theories. Jensen observed
2005, as summarized in Figure 53.1. We see that net income that companies that generate free cash flow should dis-
grew each year, with the exception of 1995, and that sales gorge that cash rather than invest the funds in less
grew each year. profitable investments. There are many ways in which

$325 $25
Revenues
$300
$275 Operating profit
$20
$250 Net profit
Revenues in billions

$225
Profit in billions

$200 $15
$175
$150
$125 $10
$100
$75
$5
$50
$25
$0 $0
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Fiscal year

Figure 53.1 Wal-Mart Stores, Inc., Revenues, Operating Profit, and Net Income, 19902005
Source: Wal-Mart Stores, Inc., Annual Report, various years.
JWPR026-Fabozzi c53 June 24, 2008 21:55

MATHEMATICAL TOOLS AND TECHNIQUES FOR FINANCIAL MODELING AND ANALYSIS 573

$20 Net cash flows from operations

Net cash flows from investing activities
$15
Net cash flows from financing activities
$10
Cash flow in billions

$5

$0

$5

$10

$15

$20
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005
Figure 53.2 Wal-Mart Stores, Inc., Cash Flows, 19902005
Source: Wal-Mart Stores, Inc., Annual Report, various year.

companies can disgorge this excess cash flow, including These two companies have identical cash flows and
the payment of cash dividends, the repurchase of stock, the same total capital expenditures. However, the Win-
and debt issuance in exchange for stock. The debt-for- ner Company spends only on profitable projects (in terms
stock exchange, for example, increases the companys of positive net present value projects), whereas the Loser
leverage and future debt obligations, obligating the future Company spends on both profitable projects and waste-
use of excess cash flow. If a company does not disgorge ful projects. The Winner Company has a lower free cash
this free cash flow, there is the possibility that another flow than the Loser Company, indicating that they are us-
companya company whose cash flows are less than its ing the generated cash flows in a more profitable manner.
profitable investment opportunities or a company that is The lesson is that the existence of a high level of free cash
willing to purchase and lever-up the companywill at- flow is not necessarily goodit may simply suggest that
tempt to acquire the free-cash-flow-laden company. the company is either a very good takeover target or the
As a case in point, Jensen observed that the oil indus- company has the potential for investing in unprofitable
try illustrates the case of wasting resources: The free cash investments.
flows generated in the 1980s were spent on low-return Positive free cash flow may be good or bad news; like-
exploration and development and on poor diversification wise, negative free cash flow may be good or bad news:
attempts through acquisitions. He argues that these com-
panies would have been better off paying these excess
cash flows to shareholders through share repurchases or
exchanges with debt. Good News Bad News
By itself, the fact that a company generates free cash flow Positive The company is The company is
is neither good nor bad. What the company does with this free cash generating substantial generating more cash
free cash flow is what is important. And this is where it is flow operating cash flows, flows than it needs for
important to measure the free cash flow as that cash flow beyond those necessary profitable projects and
in excess of profitable investment opportunities. Consider for profitable projects. may waste these cash
the simple numerical exercise with the Winner Company flows on unprofitable
and the Loser Company: projects.
Negative The company has more The company is unable
free cash profitable projects than to generate sufficient
flow it has operating cash operating cash flows to
Winner Loser flows and must rely on satisfy its investment
Company Company external financing to needs for future
fund these projects. growth.
Cash flow before capital expenditures $1,000 $1,000
Capital expenditures, positive net (750) (250)
present value projects
Capital expenditures, negative net 0 (500) Therefore, once the free cash flow is calculated, other
present value projects information (e.g., trends in profitability) must be consid-
Cash flow $250 $250
ered to evaluate the operating performance and financial
Free cash flow $250 $750
condition of the firm.
JWPR026-Fabozzi c53 June 24, 2008 21:55
574 Cash-Flow Analysis
CALCULATING FREE CASH FLOW
There is some confusion when this theoretical concept is
applied to actual companies. The primary difficulty is that
the amount of capital expenditures necessary to maintain
the business at its current rate of growth is generally not
known; companies do not report this item and may not
even be able to determine how much of a periods capi-
tal expenditures are attributed to maintenance and how
much are attributed to expansion.
Consider Procter & Gambles property, plant, and equip-
ment for 2002, which comprise some, but not all, of P&Gs
capital investment:
Additions to property, plant, and $1,679 million
equipment
Dispositions of property, plant, and (227)
equipment
Net change before depreciation $1,452 million
(In addition to the traditional capital expenditures (that
is, changes in property, plant, and equipment), P&G also
has cash flows related to investment securities and acqui-
sitions. These investments are long-term and are hence
part of P&Gs investment activities cash outflow of $6,835
million.)
How much of the $1,679 million is for maintaining
P&Gs current rate of growth and how much is for ex-
pansion? Though there is a positive net change of $1,452
million, does it mean that P&G is expanding? Not neces-
sarily: The additions are at current costs, whereas the dis-
positions are at historical costs. The additions of $1,679 are
less than P&Gs depreciation and amortization expense for
2001 of $1,693 million, yet it is not disclosed in the financial
reports how much of this latter amount reflects amortiza-
tion. (P&Gs depreciation and amortization are reported
together as $1,693 million on the statement of cash flows.)
The amount of necessary capital expenditures is therefore
elusive.
Some estimate free cash flow by assuming that all capi-
tal expenditures are necessary for the maintenance of the
current growth of the company. Though there is little jus-
tification in using all expenditures, this is a practical solu-
tion to an impractical calculation. This assumption allows
us to estimate free cash flows using published financial
statements.
Another issue in the calculation is defining what is truly
free cash flow. Generally, we think of free cash flow
as that being left over after all necessary financing expen-
ditures are paid; this means that free cash flow is after
interest on debt is paid. Some calculate free cash flow
before such financing expenditures, others calculate free
cash flow after interest, and still others calculate free cash
flow after both interest and dividends (assuming that divi-
dends are a commitment, though not a legal commitment).
There is no one correct method of calculating free cash
flow and different analysts may arrive at different esti-
mates of free cash flow for a company. The problem is that
it is impossible to measure free cash flow as dictated by
the theory, so many methods have arisen to calculate this
cash flow. A simple method is to start with the cash flow
from operations and then deduct capital expenditures. For
P&G in 2002,
Cash flow from operations $7,742
Deduct capital expenditures (1,692)
Free cash flow $6,050
Though this approach is rather simple, the cash flow
from the operations amount includes a deduction for in-
terest and other financing expenses. Making an adjust-
ment for the after-tax interest and financing expenses, as
we did earlier for Procter & Gamble,
Cash flow from operations (as reported) $7,742
Adjustment 392
Cash flow from operations (as adjusted) $8,134
Deduct capital expenditures (1,692)
Free cash flow $6,442
We can relate free cash flow directly to a companys
income. Starting with net income, we can estimate free
cash flow using four steps:
Step 1: Determine earnings before interest and taxes
(EBIT).
Step 2: Calculate earnings before interest but after taxes.
Step 3: Adjust for noncash expenses (e.g., depreciation).
Step 4: Adjust for capital expenditures and changes in
working capital.
Using these four steps, we can calculate the free cash
flow for Procter & Gamble for 2002, as shown in Table
53.5.
NET FREE CASH FLOW
There are many variations in the calculation of cash flows
that are used in analyses of companies financial condition
and operating performance. As an example of these varia-
tions, consider the alternative to free cash flow developed
by Fitch, a company that rates corporate debt instruments.
This cash flow measure, referred to as net free cash flow
(NFCF), is free cash flow less interest and other financing
costs and taxes. In this approach, free cash flow is defined
as earnings before depreciation, interest, and taxes, less
capital expenditures. Capital expenditures encompass all
capital spending, whether for maintenance or expansion,
and no changes in working capital are considered.
The basic difference between NFCF and free cash flow is
that the financing expensesinterest and, in some cases,
dividendsare deducted. If preferred dividends are per-
ceived as nondiscretionarythat is, investors come to ex-
pect the dividendsdividends may be included with the
interest commitment to arrive at net free cash flow. Oth-
erwise, dividends are deducted from net free cash flow to
produce cash flow. Another difference is that NFCF does
not consider changes in working capital in the analysis.
Further, cash taxes are deducted to arrive at net free
cash flow. Cash taxes are the income tax expense restated
to reflect the actual cash flow related to this obligation,
rather than the accrued expense for the period. Cash taxes
JWPR026-Fabozzi c53 June 24, 2008 21:55

MATHEMATICAL TOOLS AND TECHNIQUES FOR FINANCIAL MODELING AND ANALYSIS 575

Table 53.5 Calculation of Procter & Gambles Free Cash Flow for 2002, in Millions*

Step l:
Net income $4,352
Add taxes 2,031
Add interest 603
Earnings before interest and taxes $6,986
Step 2:
Earnings before interest and taxes $6,986
Deduct taxes (@35%) (2.445)
Earnings before interest $4,541
Step 3:
Earnings before interest $4,541
Add depreciation and amortization 1,693
Add increase in deferred taxes 389
Earnings before noncash expenses $6,623
Step 4:
Earnings before noncash expenses $6,623
Deduct capital expenditures (1,679)
Add decrease in receivables $96
Add decrease in inventories 159
Add cash flows from changes in accounts payable, accrued 684
expenses, and other liabilities
Deduct cash flow from changes in other operating assets and (98)
liabilities
Cash flow from change in working capital accounts 841
Free cash flow $5,785
* Procter & Gambles fiscal year ended June 30, 2002. Charges in operating accounts are taken from Procter & Gambles Statement of
Cash Flows.

are the income tax expense (from the income statement) Net cash flow gives an idea of the unconstrained cash
adjusted for the change in deferred income taxes (from the flow of the company. This cash flow measure may be use-
balance sheets). For Procter & Gamble in 2002, ful from a creditors perspective in terms of evaluating the
companys ability to fund additional debt. From a share-
Income tax expense $2,031 holders perspective, net cash flow (that is, net free cash
Deduct increase in deferred income tax (389) flow net of dividends) may be an appropriate measure
Cash taxes $1,642 because this represents the cash flow that is reinvested in
the company.
(Note that cash taxes require taking the tax expense and
either increasing this to reflect any decrease in deferred
taxes [that is, the payment this period of tax expense
recorded in a prior period] or decreasing this amount to USEFULNESS OF CASH FLOWS IN
reflect any increase in deferred taxes [that is, the deferment FINANCIAL ANALYSIS
of some of the tax expense].) The usefulness of cash flows for financial analysis depends
In the case of Procter & Gamble for 2002, on whether cash flows provide unique information or pro-
vide information in a manner that is more accessible or
EBIT $6,986 convenient for the analyst. The cash flow information pro-
Add depreciation and amortization 1,693 vided in the statement of cash flows, for example, is not
EBITDA $8,679
necessarily unique because most, if not all, of the informa-
Deduct capital expenditures (1,679)
tion is available through analysis of the balance sheet and
Free cash flow $7,000
Deduct interest (603) income statement. What the statement does provide is a
Deduct cash taxes (1,642) classification scheme that presents information in a man-
Net free cash flow $4,755 ner that is easier to use and, perhaps, more illustrative of
Deduct cash common dividends (2,095) the companys financial position.
Net cash flow $2,660 An analysis of cash flows and the sources of cash flows
can reveal the following information:
The free cash flow amount per this calculation differs r The sources of financing the companys capital
from the $5,785 that we calculated earlier for two reasons: spending. Does the company generate internally (that
Changes in working capital and the deduction of taxes on is, from operations) a portion or all of the funds needed
operating earnings were not considered. for its investment activities? If a company cannot gen-
JWPR026-Fabozzi c53 June 24, 2008 21:55
576
$150,000
Operating income (loss)
$100,000 Net income (loss)
$50,000
Income $0
in thousands
$50,000
$100,000
$150,000
$200,000
$250,000
1/31/1999
2/1/1998
Figure 53.3 Krispy, Kreme Doughnuts, Inc. Income, 19972006
Source: Krispy Kreme Doughnuts, Inc., 10-K filings, various years.
erate cash flow from operations, this may indicate prob-
lems up ahead. Reliance on external financing (e.g., eq-
uity or debt issuance) may indicate a companys inabil-
ity to sustain itself over time.
r The companys dependence on borrowing. Does the
company rely heavily on borrowing that may result in
difficulty in satisfying future debt service?
r The quality of earnings. Large and growing differences
between income and cash flows suggest a low quality
of earnings.
Consider the financial results of Krispy Kreme Dough-
nuts, Inc., a wholesaler and retailer of donuts. Krispy
Kreme grew from having fewer than 200 stores before
its initial public offering (IPO) in 2000 to over 400 stores at
the end of its 2005 fiscal year. Accompanying this growth
in stores is the growth in operating and net income, as we
show in Figure 53.3. The growth in income continued after
the IPO as the number of stores increased, but the tide in
income turned in the 2004 fiscal year and losses continued
into the 2005 fiscal year as well.
Krispy Kremes growth just after its IPO was financed
by both operating activities and external financing, as we
show in Figure 53.4. However, approximately half of the
funds to support its rapid growth and to purchase some
of its franchised stores in the 20002003 fiscal years came
from long-term financing. This resulted in problems as
the companys debt burden became almost three times
its equity as revenue growth slowed by the 2005 fiscal
year. Krispy Kreme demonstrated some ability to turn
itself around in the 2006 fiscal year, partly by slowing its
expansion through new stores.
Ratio Analysis
One use of cash-flow information is in ratio analysis, pri-
marily with the balance sheet and income statement infor-
Cash-Flow Analysis
1/30/2000
1/28/2001
1/30/2005
1/29/2006
1/28/2007
2/3/2002
2/2/2003
2/1/2004
Fiscal year end
mation. Once such ratio is the cash flowbased ratio, the
cash-flow interest coverage ratio, which is a measure of fi-
nancial risk. There are a number of other cash flowbased
ratios that an analyst may find useful in evaluating the
operating performance and financial condition of a com-
pany.
A useful ratio to help further assess a companys cash
flow is the cash flow-to-capital expenditures ratio, or capital
expenditures coverage ratio:
Cash flow
Cash flow-to-capital expenditures =
Capital expenditures
The cash-flow measure in the numerator should be one
that has not already removed capital expenditures; for
example, including free cash flow in the numerator would
be inappropriate.
This ratio provides information about the financial flexi-
bility of the company and is particularly useful for capital-
intensive firms and utilities (see Fridson, 1995, p. 173). The
larger the ratio, the greater the financial flexibility. How-
ever, one must carefully examine the reasons why this
ratio may be changing over time and why it might be
out of line with comparable firms in the industry. For ex-
ample, a declining ratio can be interpreted in two ways.
First, the firm may eventually have difficulty adding to
capacity via capital expenditures without the need to bor-
row funds. The second interpretation is that the firm may
have gone through a period of major capital expansion
and therefore it will take time for revenues to be gener-
ated that will increase the cash flow from operations to
bring the ratio to some normal long-run level.
Another useful cash flow ratio is the cash flow-to-debt
ratio:
Cash flow
Cash flow to debt =
Debt
JWPR026-Fabozzi c53 June 24, 2008 21:55
MATHEMATICAL TOOLS AND TECHNIQUES FOR FINANCIAL MODELING AND ANALYSIS
Operating activities
Financing activities
$100,000 Investing activities
$50,000
Cash flow $0
in thousands
$50,000
$100,000
$150,000
$200,000
1/31/1999
1/30/2000
1/28/2001
2/1/1998
Figure 53.4 Krispy, Kreme Doughnuts, Inc., Cash flows, 19972006
Source: Krispy, Kreme Doughnuts, Inc., 10-K filings, various years.
where debt can be represented as total debt, long-term
debt, or a debt measure that captures a specific range of
maturity (e.g., debt maturing in five years). This ratio gives
a measure of a companys ability to meet maturing debt
obligations. A more specific formulation of this ratio is
Fitchs CFAR ratio, which compares a companys three-
year average net free cash flow to its maturing debt over
the next five years (see McConville, 1996). By comparing
the companys average net free cash flow to the expected
obligations in the near term (that is, five years), this ratio
provides information on the companys credit quality.
Using Cash-Flow Information
The analysis of cash flows provides information that can
be used along with other financial data to help assess the
financial condition of a company. Consider the cash flow-
to-debt ratio calculated using three different measures of
cash flowEBITDA, free cash flow, and cash flow from
operations (from the statement of cash flows)each com-
pared with long-term debt, as shown in Figure 53.5 for
Weirton Steel.
This example illustrates the need to understand the dif-
ferences among the cash flow measures. The effect of cap-
ital expenditures in the 19881991 period can be seen by
the difference between the free-cash-flow measure and the
other two measures of cash flow; both EBITDA and cash
flow from operations ignore capital expenditures, which
were substantial outflows for this company in the earlier
period.
Cash-flow information may help a stock or bond analyst
identify companies that may encounter financial difficul-
ties. Consider the study by Largay and Stickney (1980) that
analyzed the financial statements of W. T. Grant during the
19661974 period preceding its bankruptcy in 1975 and
ultimate liquidation. They noted that financial indicators
577
1/30/2005
1/29/2006
2/28/2007
2/3/2002
2/2/2003
2/1/2004
Fiscal year end
such as profitability ratios, turnover ratios, and liquidity
ratios showed some downtrends, but provided no definite
clues to the companys impending bankruptcy. A study of
cash flows from operations, however, revealed that com-
pany operations were causing an increasing drain on cash,
rather than providing cash. (For the period investigated,
a statement of changes of financial position [on a working
capital basis]) was required to be reported prior to 1988.]
This necessitated an increased use of external financing,
the required interest payments on which exacerbated the
cash-flow drain. Cash-flow analysis clearly was a valuable
tool in this case since W. T. Grant had been running a neg-
ative cash flow from operations for years. Yet none of the
traditional ratios discussed above take into account the
cash flow from operations. Use of the cash flow-to-capital
expenditures ratio and the cash flow-to-debt ratio would
have highlighted the companys difficulties.
Dugan and Samson (1996) examined the use of operat-
ing cash flow as an early warning signal of a companys
potential financial problems. The subject of the study
was Allied Products Corporation because for a decade
this company exhibited a significant divergence between
cash flow from operations and net income. For parts of
the period, net income was positive while cash flow from
operations was a large negative value. In contrast to W. T.
Grant, which went into bankruptcy, the auditors report
in the 1991 Annual Report of Allied Products Corporation
did issue a going-concern warning. Moreover, the stock
traded in the range of $2 to $3 per share. There was then
a turnaround of the company by 1995. In its 1995 annual
report, net income increased dramatically from prior pe-
riods (to $34 million) and there was a positive cash flow
from operations ($29 million). The stock traded in the $25
range by the Spring of 1996. As with the W. T. Grant study,
Dugan and Samson found that the economic realities of a
firm are better reflected in its cash flow from operations.
JWPR026-Fabozzi c53 June 24, 2008
578
50%
Cash flow estimate as a percentage of debi
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
1988
EBITDA/debt
Figure 53.5 Cash Flow to Debt Using Alternative Estimates of Cash Flow for Weirton Steel, 19881996
Source: Weirton Steels 10-K reports, various years.
The importance of cash flow analysis in bankruptcy pre-
diction is supported by the study by Foster and Ward
(1997), who compared trends in the statement of cash
flows componentscash flow from operations, cash flow
for investment, and cash flow for financingbetween
healthy companies and companies that subsequently
sought bankruptcy. They observe that healthy companies
tend to have relatively stable relations among the cash
flows for the three sources, correcting any given years de-
viation from their norm within one year. They also observe
that unhealthy companies exhibit declining cash flows
from operations and financing and declining cash flows
for investment one and two years prior to the bankruptcy.
Further, unhealthy companies tend to expend more
cash flows to financing sources than they bring in dur-
ing the year prior to bankruptcy. These studies illustrate
the importance of examining cash flow information in as-
sessing the financial condition of a company.
SUMMARY
The term cash flow has many meanings and the chal-
lenge is to determine the cash-flow definition and calcu-
lation that is appropriate. The simplest calculation of cash
flow is the sum of net income and noncash expenses. This
measure, however, does not consider other sources and
uses of cash during the period.
The statement of cash flows provides a useful break-
down of the sources of cash flows: operating activities,
investing activities, and financing activities. Though at-
tention is generally focused on the cash flows from opera-
tions, what the company does with the cash flows (that is,
21:55
Cash-Flow Analysis
1989 1990 1991 1992 1993 1994 1995 1996
Free cash flow/debt Cash flow from operation/debt
investing or paying off financing obligations) and what are
the sources of invested funds (that is, operations versus
external financing) must be investigated. Minor adjust-
ments can be made to the items classified in the statement
of cash flows to improve the classification.
Examination of the different patterns of cash flows is
necessary to get a general idea of the activities of the
company. For example, a company whose only source of
cash flow is from investing activities, suggesting the sale
of property or equipment, may be experiencing financial
distress.
Free cash flow is a companys cash flow that remains
after making capital investments that maintain the com-
panys current rate of growth. It is not possible to calcu-
late free cash flow precisely, resulting in many different
variations in calculations of this measure. A company that
generates free cash flow is not necessarily performing well
or poorly; the existence of free cash flow must be taken in
context with other financial data and information on the
company.
One of the variations in the calculation of a cash-flow
measure is net free cash flow, which is, essentially, free
cash flow less any financing obligations. This is a measure
of the funds available to service additional obligations to
suppliers of capital.
REFERENCES
Bernstein, L. A. (1999). Analysis of Financial Statements. 5th
edition. New York: McGraw Hill.
Dugan, M. T., and Samson, W. D. (1996). Operating
cash flow: Early indicators of financial difficulty and
JWPR026-Fabozzi c53 June 24, 2008 21:55
MATHEMATICAL TOOLS AND TECHNIQUES FOR FINANCIAL MODELING AND ANALYSIS
recovery. Journal of Financial Statement Analysis, Sum-
mer: 4150.
Eastman, K. (1997). EBITDA: An overrated tool for cash
flow analysis. Commercial Lending Review, January-
February: 6469.
Fabozzi, F. J., Drake, P. P., and Polimeni, R. S. (2007). The
Complete CFO Handbook: From Accounting to Accountabil-
ity. Hoboken, NJ: John Wiley & Sons.
Fridson, M. (1995). Financial Statement Analysis: A Practi-
tioners Guide. New York: John Wiley & Sons.
Jensen, M. C. (1986). Agency costs of free cash flow, corpo-
rate finance, and takeovers. American Economic Review
76, 2: 323329.
579
Largay, J. A., and Stickney, C. P. (1980). Cash flows, ra-
tio analysis and the W. T. Grant company bankruptcy.
Financial Analysts Journal July/August: 5154.
McConville, D. J. (1996). Cash flow ratios gains respect
as useful tool for credit Rating. Corporate Cashflow,
January: 18.
Peterson, P. P., and Fabozzi, F. J. (2006). Analysis of Financial
Statements, 2nd edition. Hoboken, NJ: John Wiley &
Sons.
Stumpp, P. M. (2001). Critical failings of EBITDA as a cash
flow measure. In F. J. Fabozzi (ed.), Bond Credit Analysis:
Framework and Case Studies (pp. 139170). Hoboken, NJ:
John Wiley & Sons.
JWPR026-Fabozzi c53 June 24, 2008 21:55

580