1. Read and summarize chapter 24 of the Financial Management book in at least 500 words.
– Answer the following questions as well:
– Explain “free cash flow.”
– How is it calculated?
– What is a statement of cash flow?
CHP24 ; Cash Flow Analysis
n objective of financial analysis is to assess a company’s operating
performance and financial condition. The information that an analyst
has available 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. However, the choices
available in the accrual accounting system make it difficult to compare
companies’ performance. These choices also provide the opportunity for
the management of financial numbers through judicious choice of
accounting methods. For example, $1 of net income for one company
may not be equivalent to $1 of net income of another company. Cash
flows provide the financial analyst with a way of transforming net
income based on an accrual system to a more comparable medium. Addi-
tionally, cash flows are essential ingredients in valuation: The value of a
company today is the present value of its expected future cash flows.
Therefore, understanding past and current cash flows may help the analyst in forecasting future cash flows and, hence, determine the value of
the company. Moreover, understanding cash flow allows an analyst to
assess the ability of a firm to maintain current dividends and its current
capital expenditure policy without relying on external financing.
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 business, and a com-
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798 FINANCIAL STATEMENT ANALYSIS
pany’s 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 the net
of the cash inflows and outflows for a period? Well, there is no specific
definition of cash flow—and that’s probably why there is so much con-
fusion regarding the measurement of cash flow. Ideally, the analyst
needs a measure of the company’s operating performance that is compa-
rable among companies—something other than net income.
A simple, yet crude method of calculating cash flow requires 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:
This amount is not really a cash flow, but simply earnings before depre-
ciation and amortization. Is this a cash flow that analysts should use in
valuing a company? Though not a cash flow, this estimated cash flow
does allow a quick comparison of income across firms that may use dif-
ferent depreciation methods and depreciable lives.1
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 generates sales for the period. Sales and the
accompanying cost of goods sold are reflected in the period’s net income
and the estimated cash flow amount. However, until the account receiv-
able is collected, there is no cash from this transaction. If collection does
not occur until the next period, 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
Another estimate of cash flow that is simple to calculate is EBITDA—
earnings before interest, taxes, depreciation, and amortization. However,
this measure suffers from the same accrual-accounting bias as the previ-
ous measure, which may result in the omission of significant cash flows.
Estimated cash flow = Net income + depreciation and amortization
Estimated cash flow = $4,352 million + 1,693 million
= $6,045 million
1 An example of the use of this estimate of cash flow, The Value Line Investment Sur-
vey, 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, available at http://www.valueline.com].
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