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A review of EDGAR filings, the SEC system for which public companies transmit financial information, finds over 90% of reporting companies defining free cash flow as operating cash flow minus capital expenditures Example:

MORRIS TOWNSHIP, N.J., January 28, 2011-- Honeywell (NYSE: HON) today announced full-year 2010 sales increased 8% to $33.4 billion vs. $30.9 billion in 2009. Earnings per share (proforma) were up 12% to $3.00 versus $2.69 in the prior year, excluding the unfavorable impact of the pension mark-to-market adjustment. Reported earnings per share for 2010 were $2.59 versus $2.05 in the prior year. Free cash flow (cash flow from operations less capital expenditures) was a record $3.6 billion (cash flow from operations of $4.2 billion).

Source: Honeywell 8K

Unfortunately, corporate financial reporting does not often provide investors with an accurate assessment of the real free cash flows, and hence adjustments to reported financial statements are required. Free cash flow should be defined as the maximum amount of cash an entity could distribute to shareholders without impairing its rate of growth or through return of capital.

Hence, it is up to the analyst to reclassify those financing and investing activities which are more appropriately operating activities and, as such, would provide (potential) investors with a more realistic indication of the true free cash flow generating capacity of the enterprise. This is true even though classification of a particular activity is prescribed or generally accepted, as we see in the examples below.

Example:

For “payments to noncontrolling interests”, to whom as long as they continue to operate profitable operations may be due cash, payments are classified as financing activities while the purchase of the noncontrolling interests would be classified as an investing activity. Unfortunately, for investors who fail to reclassify the payments to the operating activity section, under the common definition of free cash flow, the reader of the financial statement is left with the impression of exaggerated, and incorrect, free cash flows.

For instance, AmSurg Corporation (AMSG), in partnership with physicians, operates surgery centers, where the partnerships may result in cash payments due the minority owners. Such operating cash payments which may result from profitable locations are as much a cost of doing business as payment of salaries or taxes. In common practice, the company classifies these outflows as Financing Activities, the payments representing “outflows or other distributions to owners”, as set forth under FAS 95.

Under the microscope of free cash flow, where free cash represents the income to shareholders of the common stock, the analyst would need to deduct such outflows, which in AmSurg’s case, is sizeable, accounting for over half of reported Cash Flow from Operating Activities (see below). To do otherwise would seriously misrepresent free cash flows as these payments could not be given to shareholders without impairing capital.

To conclude that AmSurg had free cash flows of $214 MM (we add sale of PPE in the Statement shown) would be incorrect. The analyst would need to reclassify the $130.9 MM as an operating activity from which capital spending and proceeds from PPE would be factored, leaving free cash flow as $83.1 MM, or 37% less than would normally be defined.

At CT Capital, as explained in Security Valuation and Risk Analysis, we also account for overspending in discretionary areas, so that, in the case of AmSurg, we would add $2.7 MM back to free cash flow to account for overspending in its cost of goods sold, which could represent overspending of many items in the production and sales process. We would also deduct half of the share repurchases, or $6.3MM, which represents that amount of cash necessary to maintain a steady share count over the prior year. Share based compensation has a real cost. The other half of the buyback would in fact represent free cash flow. Thus free cash flow for the year would approximate $79.5MM, which would depict the maximum distributable cash available for shareholder distribution, or free cash flow.

When making adjustments to published financial statements, the analyst must also adjust or normalcy of one-time (extraordinary) payments or events. Also, taxes, interest and dividends a firm would classify as an investing or financing activity should most often be melded into operating activities. This will also allow for better comparability.

AmSurg Corp.
Consolidated Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
(In thousands
)

2009

2008

2007

Cash flows from operating activities:

Net earnings

$

181,350

$

165,926

$

150,303

Adjustments to reconcile net earnings to net cash provided by operating activities:

Depreciation and amortization

22,927

20,815

18,648

Net loss on sale and impairment of long-lived assets

455

922

724

Share-based compensation

4,068

4,710

4,560

Excess tax benefit from share-based compensation

(32

)

(1,351

)

(3,322

)

Deferred income taxes

14,703

14,729

8,063

Increase (decrease) in cash and cash equivalents, net of effects of acquisitions and dispositions, due to changes in:

Accounts receivable, net

1,494

3,792

(2,300

)

Supplies inventory

(60

)

(83

)

47

Prepaid and other current assets

(733

)

2,344

(2,958

)

Accounts payable

1,289

(1,904

)

962

Accrued expenses and other liabilities

6,666

(487

)

8,128

Other, net

457

283

61

Net cash flows provided by operating activities

232,584

209,696

182,916

Cash flows from investing activities:

Acquisition of interests in surgery centers and related transactions

(95,826

)

(118,671

)

(162,777

)

Acquisition of property and equipment

(19,930

)

(18,379

)

(24,640

)

Proceeds from sale of interests in surgery centers

1,298

3,812

5,433

Repayment of notes receivable

1,666

1,458

2,616

Net cash flows used in investing activities

(112,792

)

(131,780

)

(179,368

)

Cash flows from financing activities:

Proceeds from long-term borrowings

137,178

157,787

178,316

Repayment on long-term borrowings

(116,951

)

(114,788

)

(89,712

)

Distributions to noncontrolling interests

(130,855

)

(118,769

)

(103,545

)

Proceeds from issuance of common stock upon exercise of stock options

201

9,970

17,661

Repurchase of common stock

(12,587

)

(12,413

)

Capital contributions and ownership transactions by noncontrolling interests

1,036

582

480

Excess tax benefit from share-based compensation

32

1,351

3,322

Financing cost incurred

(17

)

(41

)

(200

)

Net cash flows (used in) provided by financing activities

(121,963

)

(76,321

)

6,322

Net (decrease) increase in cash and cash equivalents

(2,171

)

1,595

9,870

Cash and cash equivalents, beginning of year

31,548

29,953

20,083

Exhibit 2

In the Statement of Cash Flows for Boeing (BA), we would reclassify both the “Payments to noncontrolling interests” and the “payments on guarantees” to the operating activity section, thereby reducing free cash flows. Payments on guarantees represent the impact and success of the firm's operations, including its ability and technical skills in the manufacturing process as well as their ability to provide services promised, and should therefore be considered operating, not financial or investing activities. Payment on guarantees would be considered a reversal of profits, which is an operating activity under the indirect method.

The Boeing Company and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in millions)

Years ended December 31,

2009

2008

2007

Cash flows – operating activities:

Net earnings

$

1,312

$

2,672

$

4,074

Adjustments to reconcile net earnings to net cash provided by operating activities:

Non-cash items –

Share-based plans expense

238

209

287

Depreciation

1,459

1,325

1,334

Amortization of other acquired intangibles

207

166

152

Amortization of debt discount/premium and issuance costs

12

11

(1

)

Investment/asset impairment charges, net

151

50

51

Customer financing valuation provision

45

84

(60

)

(Gain)/loss on disposal of discontinued operations

36

(28

)

(25

)

(Gain)/loss on dispositions, net

24

(4

)

(38

)

Other charges and credits, net

214

116

197

Excess tax benefits from share-based payment arrangements

(5

)

(100

)

(144

)

Changes in assets and liabilities –

Accounts receivable

(391

)

564

(392

)

Inventories, net of advances and progress billings

(1,525

)

(6,168

)

(1,577

)

Accounts payable

1,141

318

(198

)

Other accrued liabilities

1,327

554

1,126

Advances and billings in excess of related costs

(680

)

(1,120

)

2,369

Income taxes receivable, payable and deferred

607

744

1,290

Other long-term liabilities

(12

)

(211

)

71

Pension and other postretirement plans

1,140

14

(143

)

Customer financing, net

104

432

1,458

Other

199

(29

)

(247

)

Net cash provided/(used) by operating activities

5,603

(401

)

9,584

Cash flows – investing activities:

Property, plant and equipment additions

(1,186

)

(1,674

)

(1,731

)

Property, plant and equipment reductions

27

34

59

Acquisitions, net of cash acquired

(639

)

(964

)

(75

)

Contributions to investments

(2,629

)

(6,673

)

(5,710

)

Proceeds from investments

1,041

11,343

3,817

Payments on Sea Launch guarantees

(448

)

Reimbursement of Sea Launch guarantee payments

40

Purchase of distribution rights

(178

)

(182

)

Net cash (used)/provided by investing activities

(3,794

)

1,888

(3,822

)

Cash flows – financing activities:

New borrowings

5,961

13

40

Debt repayments

(551

)

(738

)

(1,406

)

Payments to noncontrolling interests

(40

)

Repayments of distribution rights financing

(357

)

Stock options exercised, other

10

44

209

Excess tax benefits from share-based payment arrangements

5

100

144

Employee taxes on certain share-based payment arrangements

(21

)

(135

)

Common shares repurchased

(50

)

(2,937

)

(2,775

)

Dividends paid

(1,220

)

(1,192

)

(1,096

)

Net cash provided/(used) by financing activities

4,094

(5,202

)

(4,884

)

Effect of exchange rate changes on cash and cash equivalents

44

(59

)

46

Net increase/(decrease) in cash and cash equivalents

5,947

(3,774

)

924

Cash and cash equivalents at beginning of year

3,268

7,042

6,11


Disclosure: I am long AMSG.

Additional disclosure: CT Capital is long AMSG for client portfolios
Source: How Analysts Can Make an Accurate Presentation of Free Cash Flow