By David Harper 
(Contact David)

In the previous section of this tutorial, we showed that cash flows through a business in four generic stages. First, cash is raised from investors and/or borrowed from lenders. Second, cash is used to buy assets and build inventory. Third, the assets and inventory enable company operations to generate cash, which pays for expenses and taxes before eventually arriving at the fourth stage. At this final stage, cash is returned to the lenders and investors. Accounting rules require companies to classify their natural cash flows into one of three buckets (as required by SFAS 95); together these buckets constitute the statement of cash flows. The diagram below shows how the natural cash flows fit into the classifications of the statement of cash flows. Inflows are displayed in green and outflows displayed in red: 

(*) Cash flow from investment (CFI) is used as an estimate of the level of net capital expenditures required to maintain and grow the company. The goal is to deduct expenditures needed to fund "ongoing" growth, and if a better estimate than CFI is available, then it should be used. 
 

Free cash flow to equity (FCFE) equals CFO minus cash flows from investments (CFI). Why subtract CFI from CFO? Because shareholders care about the cash available to them after all cash outflows, including long-term investments. CFO can be boosted merely because the company purchased assets or even another company. FCFE improves on CFO by counting the cash flows available to shareholders net of all spending, including investments. 

Free cash flow to the firm (FCFF) uses the same formula as FCFE but adds after-tax interest, which equals interest paid multiplied by [1 – tax rate]. After-tax interest paid is added because, in the case of FCFF, we are capturing the total net cash flows available to both shareholders and lenders. Interest paid (net of the company's tax deduction) is a cash outflow that we add back to FCFE in order to get a cash flow that is available to all suppliers of capital. 

A Note Regarding Taxes 
We do not need to subtract taxes separately from any of the three measures above. CFO already includes (or, more precisely, is reduced by) taxes paid. We usually do want after-tax cash flows since taxes are a real, ongoing outflow. Of course, taxes paid in a year could be abnormal. So for valuation purposes, adjusted CFO or EVA-type calculations adjust actual taxes paid to produce a more "normal" level of taxes. For example, a firm might sell a subsidiary for a taxable profit and thereby incur capital gains, increasing taxes paid for the year. Because this portion of taxes paid is non-recurring, it could be removed to calculate a normalized tax expense. But this kind of precision is not always necessary. It is often acceptable to use taxes paid as they appear in CFO. 

1. Tax Benefits Related to Employee Stock Options (See #1 on Amgen CFO statement) Amgen\'s CFO was boosted by almost $269 million because a company gets a tax deduction when employees exercise non-qualified stock options. As such, almost 8% of Amgen\'s CFO is not due to operations and is not necessarily recurring, so the amount of the 8% should be removed from CFO. Although Amgen\'s cash flow statement is exceptionally legible, some companies bury this tax benefit in a footnote.  To review the next two adjustments that must be made to reported CFO, we will consider Verizon\'s statement of cash flows below.  2. Unusual Changes to Working Capital Accounts (receivables, inventories and payables) (Refer to #2 on Verizon\'s CFO statement.)  Although Verizon\'s statement has many lines, notice that reported CFO is derived from net income with the same two sets of add backs we explained above: non-cash expenses are added back to net income and changes to operating accounts are added to or subtracted from it:  Notice that a change in accounts payable contributed more than $2.6 billion to reported CFO. In other words, Verizon created more than $2.6 billion in additional operating cash in 2003 by holding onto vendor bills rather than paying them. It is not unusual for payables to increase as revenue increases, but if payables increase at a faster rate than expenses, then the company effectively creates cash flow by "stretching out" payables to vendors. If these cash inflows are abnormally high, removing them from CFO is recommended because they are probably temporary. Specifically, the company could pay the vendor bills in January, immediately after the end of the fiscal year. If it does this, it artificially boosts the current-period CFO by deferring ordinary cash outflows to a future period.  Judgment should be applied when evaluating changes to working capital accounts because there can be good or bad intentions behind cash flow created by lower levels of working capital. Companies with good intentions can work to minimize their working capital - they can try to collect receivables quickly, stretch out payables and minimize their inventory. These good intentions show up as incremental and therefore sustainable improvements to working capital.  Companies with bad intentions attempt to temporarily dress-up cash flow right before the end of the reporting period. Such changes to working capital accounts are temporary because they will be reversed in the subsequent fiscal year. These include temporarily withholding vendor bills (which causes a temporary increase in accounts payable and CFO), cutting deals to collect receivables before the year's end (causing a temporary decrease in receivables and increase in CFO), or drawing down inventory before the year's end (which causes a temporary decrease in inventory and increase in CFO). In the case of receivables, some companies sell their receivables to a third party in a factoringtransaction, which has the effect of temporarily boosting CFO.  3. Capitalized Expenditures That Should Be Expensed (outflows in CFI that should be manually re-classified to CFO) (Refer to #3 on the Verizon CFO statement.)  Under cash flow from investing (CFI), you can see that Verizon invested almost $11.9 billion in cash. This cash outflow was classified under CFI rather than CFO because the money was spent to acquire long-term assets rather than pay for inventory or current operating expenses. However, on occasion this is a judgment call. WorldCom notoriously exploited this discretion by reclassifying current expenses into investments and, in a single stroke, artificially boosting both CFO and earnings.  Verizon chose to include 'capitalized software' in capital expenditures. This refers to roughly $1 billion in cash spent (based on footnotes) to develop internal software systems. Companies can choose to classify software developed for internal use as an expense (reducing CFO) or an investment (reducing CFI). Microsoft, for example, responsibly classifies all such development costs as expenses rather than capitalizing them into CFI, which improves the quality of its reported CFO. In Verizon's case, it's advisable to reclassify the cash outflow into CFO, reducing it by $1 billion.  The main idea here is that if you are going to rely solely on CFO, you should check CFI for cash outflows that ought to be reclassified to CFO.  4. One-Time (Nonrecurring) Gains Due to Dividends Received or Trading Gains  CFO technically includes two cash flow items that analysts often re-classify into cash flow from financing (CFF): (1) dividends received from investments and (2) gains/losses from trading securities (investments that are bought and sold for short-term profits). If you find that CFO is boosted significantly by one or both of these items, they are worth examination. Perhaps the inflows are sustainable. On the other hand, dividends received are often not due to the company's core operating business and may not be predictable. Gains from trading securities are even less sustainable: they are notoriously volatile and should generally be removed from CFO unless, of course, they are core to operations, as with an investment firm. Further, trading gains can be manipulated: management can easily sell tradable securities for a gain prior to the year's end, boosting CFO.

• Remove gains from tax benefits due to stock option exercises.
• Check for temporary CFO blips due to working capital actions. For example, withholding payables, or "stuffing the channel", to temporarily reduce inventory.
• Check for cash outflows classified under CFI that should be reclassified to CFO.
• Check for other one-time CFO blips due to nonrecurring dividends or trading gains.

http://www.investopedia.com/university/financialstatements/financialstatements3.asp