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Penman: Financial

Statement Analysis and


Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Chapter Ten
LINKS
Link to previous chapter
Chapter 9 reformulated the
balance sheet and income
statement to capture the
operating and financing
activities.

The Analysis of the


Cash Flow Statement

This chapter
This chapter reformulates
the cash flow statement to
capture the operating and
financing activities.

Link to next chapter


Chapter 11 lays out the
analysis of the reformulated
financial statements.

Link to Web page


Review the statement of
cash flows for more
companiesvisit
the book's Web Site at
www.mhhe.com/
penman3e.

How is the cash


flow statement
reformulated to
separate
operating and
financing
flows?

How is free cash


flow identified
in reformulated
statements?

What
adjustments
must be made
to GAAP
cash flow
statements?

This chapter completes the preparation of the nancial statements for analysis by reformulating the cash ow statement. The cash ow statement describes the cash generation in a
business, and reformulation highlights the cash ows that are important to analysis.
If the equity analyst is using accounting-based valuation, he is concerned with protability rather than cash ow, so his primary focus is on the balance sheet and income statement
from which the protability is calculated. But he cannot ignore the cash ow statement.
Equity valuation relies on accrual accounting numbers and accrual accounting numbers can
be distorted. A difference between accrual accounting earnings and operating cash ow is a
red ag that could indicate manipulation, so the analyst must scrutinize the cash ows as
well as accrual accounting earnings. Indeed earnings will be compared to cash ows in the
analysis of the quality of earnings in Chapter 17.
If the equity analyst chooses to apply discounted cash ow (DCF) analysis, (as in Chapter 4), the cash ow statement becomes the primary focus. This analyst has the primary task
of forecasting free cash ows; to do so, he must have a good appreciation of the cash ow
statement.
Equity valuation issues aside, the analysis of the cash ow statement is necessary for
liquidity analysis and nancial planning, which will be covered in Part Five of the book.
Liquidity analysis is involved in assessing the risk of debt, for liquidity (cash) is required
to settle debt. So liquidity analysis is very much the tool of the credit analyst. Financial
planning is the tool of the treasurer. She must ensure that nancing is in place to meet the
needs for cashto make investments and cover dividends, as well as servicing debt. To understand the needs for cash, she must analyze the ability of the rm to generate cash. Like

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Chapter 10 The Analysis of the Cash Flow Statement 347

The Analysts Checklist


After reading this chapter you should understand:

After reading this chapter you should be able to:

How free cash ow can be calculated from reformulated income statements and balance sheets without a
cash ow statement.

Calculate free cash ow from reformulated income


statements and balance sheets.

How the cash conservation equation ties the cash ow


statement together to equate free cash ow and nancing cash ow.
The difference between the direct and indirect calculations of cash from operations.
Problems that arise in analyzing cash ows from GAAP
statements of cash ow.

Calculate free cash ow by adjusting GAAP cash ow


statements.
Reformulate GAAP statements of cash ow to identify
operating, investing, and nancing cash ows distinctly.
Reconcile the free cash ow from GAAP statements to
that calculated from reformulated income statements
and balance sheets.

What reformulated cash ow statements tell you.


How to examine the quality of reported cash ow from
operations.

valuation analysis, liquidity analysis and nancial planning are prospective: The credit analyst and the treasurer are concerned about the ability of the rm to generate cash in the future, and they use current nancial statements to forecast future cash ow statements. The
analysis here, like that of the other statements, prepares you for forecasting. Chapter 19
completes the task.
Unfortunately, GAAP statements of cash ow are not in the form that identies the cash
ows used in these analyses, and indeed they misclassify some cash ows. Operating cash
ows are confused with nancing ows. This chapter reformulates the statement to distinguish the cash ows appropriately. The reformulation is important for preparing pro forma
future cash ow statements for DCF analysis, liquidity analysis, and nancial planning. If
the analyst forecasts GAAP cash ows, a DCF valuation will be incorrect and a misleading
picture of liquidity and nancing needs will be drawn.
An important lesson emerges from this chapter. Forecasting free cash ow is best done by
forecasting reformulated income statements and balance sheets. We can contemplate forecasting cash ow statements, but this is difcult without rst forecasting the protability of
operations, understood from reformulated income statements and balance sheets. Once
those statements are forecasted, free cash ow forecasts can be calculated immediately, as
the rst section of the chapter shows. And GAAP cash ow statements are messy, as the second section of the chapter shows; dealing with them requires considerable adjustment.

THE CALCULATION OF FREE CASH FLOW


Free cash owthe difference between cash ow from operations and cash investment in
operationsis the main focus in DCF analysis, liquidity analysis, and nancial planning.
Free cash ow is the net cash generated by operations, which determines the ability of the
rm to pay off its debt and equity claims.
If the analyst has gone through the analysis of the balance sheet and income statement
in Chapter 9, he does not need a cash ow statement to get the free cash ow. If those

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Nike, Inc.: Calculation of Free Cash Flow


for 2004 (in millions)
Method 1:

Method 2:

C I = OI NOA
Operating income
Net operating assets
Net operating assets
Free cash ow

2004
2004
2003
2004

C I = NFE NFO + d
Net nancial expenses
Net nancial obligations
Net nancial obligations
Net dividend
Free cash ow

2004
2004
2003
2004
2004

10.1

$1,035
$4,551
4,330

(221)
$ 814
$

$ (289)
302

16

591
207
$ 814

statements are appropriately formatted, then the free cash ow is given by a quick calculation. In Chapter 7 we saw that
Free cash ow = Operating income Change in net operating assets

(10.1)

C I = OI NOA
That is, free cash ow is operating income (in a reformulated income statement) less the
change in net operating assets in the balance sheet.
For this quick calculation to work, the operating income must, of course, be comprehensive. Just as comprehensive income and changes in the book value of equity explain
dividends to shareholders, so comprehensive operating income and the change in the book
value of the net operating assets explain the dividend from the operating activities to the
nancing activities, the free cash ow.
The numbers for operating income and net operating assets for Nike, Inc., from Exhibits 9.3 and 9.9 in Chapter 9 are provided in Box 10.1, and free cash ow is calculated
from these numbers under Method 1. Nike generated income from operations of $1,035
million, but its additional investment in net operating assets of $221 million produced a
free cash ow of $814 million.
There is a second way to calculate free cash ow from reformulated statements. In
Chapter 7 we also saw that free cash ow is applied as follows:
Free cash ow = Net nancial expense
Change in net nancial obligations
+ Net dividends

(10.2)

C I = NFE NFO + d
that is, free cash ow is used to pay for net nancial expense, reduce debt, and pay net dividends. If minority interests are involved, the calculation is
C I = NFE NFO + d + Minority interest in income
Minority interest in the balance sheet

(10.2a)

Again, the net nancial expense must be comprehensive (of unrealized gains and losses on
nancial assets, for example, and of the tax benet from interest expense). This second
calculation is given for Nike, Inc., under Method 2 in Box 10.1. The net dividend is from
the reformulated statement of common shareholders equity in Exhibit 9.8 in Chapter 9.
348

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Reebok International Ltd.: Calculation of Free


Cash Flow for 2004 (in millions)
Method 1:

Method 2:

C I = OI NOA
Operating income
Net operating assets
Net operating assets
Free cash ow

2004
2004
2003
2004

C I = NFE NFO + d + MI in
income MI in balance sheet
Net nancial expenses
Net nancial obligations
Net nancial obligations
Net dividend
Minority interest in income
Change in minority interest in balance sheet
Free cash ow (allow for refunding error)

2004
2004
2003
2004
2004
2004
2004

10.2

$ 237
$1,212
731

481
$(244)

$ 18
$

(23)
(316)

(293)
23
5
3
$(244)

The two calculations must agree if the reformulation of the equity statement is done on a
comprehensive basis. The calculations in Box 10.2 are based on the reformulated statements
for Reebok in Exhibits 9.4 and 9.10 in Chapter 9 and, for the net dividend, the reformulated
equity statement in Exhibit 9.8 in Chapter 9. Note that Reebok has minority interest.
If the balance sheet and income statement have been reformulated, these calculations are
straightforward. Youll agree that these methods are much simpler than the seven-step
approach to calculating free cash ow in Chapter 4. But, you may ask, Cant I simply read
the cash ows on the statement of cash ows? This is not as easy as you would think.

GAAP STATEMENT OF CASH FLOWS AND REFORMULATED


CASH FLOW STATEMENTS
For cash ow forecasting we need to distinguish clearly the cash generated by operations
(the free cash ow) from the ows that involve paying that cash ow out to the rms
claimants. If operations use cash (and thus have negative free cash ow), we need to distinguish that negative free cash ow from the cash ows that involve claimants paying into the
rm to cover the free cash ow decit. An analyst forecasting free cash ow for discounted
cash ow analysis must not confuse the free cash ow with the nancing ows. And a treasurer forecasting the cash needs of the business must forecast the cash surplus or decit as
distinct from the nancing ows that will dispose of the surplus or will be needed to meet
the decit.
As with the income statement and balance sheet, the template in Chapter 7 guides the reformulation of the cash ow statement to identify cash ows appropriately. Review that
chapter before beginning this one; focus on Figure 7.3. Four types of cash ow are identied there. Two are cash ows generated by the operating activities within the rm: cash
from operations (C) and cash investments in those operations (I). Two involve nancing activities between the rm and its claimants outside the rm: net dividends to shareholders
(d) and net payments to debtholders and issuers (F). The reformulated cash ow statement
gives the details of these four ows.
349

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

10. The Analysis of the


Cash Flow Statement

The McGrawHill
Companies, 2007

350 Part Two The Analysis of Financial Statements

The four cash ows are tied together according to the cash conservation equation that
was introduced in Chapter 7:
Free cash ow = Net payments to shareholders + Net payments to debtholders and issuers
CI=d+F
Free cash ow from operations (on the left) is applied (on the right) to nancing payments to
shareholders (as net dividends, d) and debtholders and issuers (as interest and principal payments, F). Free cash ow can be negative, in which case the nancing ows to claimants must
be negative, in the form of cash from share issues, debt issues, or the sale of nancial assets.
The GAAP statement of cash ows has the appearance of giving us the free cash ow
and the ows for nancing activities, but it somewhat confuses the two. The form of the
statement appears below, along with the form of the reformulated statement that follows the
cash conservation equation. The GAAP statement can come in two forms,
GAAP Statement of Cash Flows

Cash ow from operations


Cash used in investing activities
+ Cash from nancing activities
= Change in cash and cash equivalents
Reformulated Statement of Cash Flows

Cash ow from operations


Cash investments
= Free cash ow from operating activities
Cash paid to shareholders
+ Cash paid to debtholders and issuers
= Cash paid for nancing activities

one using the direct method and one using the indirect method. Box 10.3 explains the direct
and indirect presentations.

Reclassifying Cash Transactions


Exhibit 10.1 gives Nikes 2004 comparative statement of cash ows. This statement uses
the indirect method of presentation. Nike reports cash from operations of $1,514.4 million
in 2004 and cash investment of $946.5 million so we might conclude that free cash ow
equals the difference, $567.9 million. This number disagrees with our earlier calculation
(in Box 10.1) of $814 million. Which is correct?
The GAAP statement of cash ows is governed by FASB Statement No. 95. The statement suffers from a number of deciencies for equity analysis purposes, including transparent misclassications of cash ow. Here are the main problems we encounter in trying
to discover free cash ow from the GAAP statement.1 Some have already been encountered
in the discussion in Chapter 4.
1. Change in cash and cash equivalents. The GAAP statement is set up to explain the
change in cash and cash equivalents (agged 1 in Nikes statement). But cash generated
has to be disposed of somewhere. Any change in cash needed for operations (working
cash) is an investment in an operating asset that should be included in the cash investment
section. The change in cash equivalents that earn interest is an investment of excess cash
1
For a more detailed review, see H. Nurnberg, Inconsistencies and Ambiguities in Cash Flow Statements
under FASB Statement No. 95, Accounting Horizons, June 1993, pp. 6075.

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Direct and Indirect Method Cash


Flow Statements
The direct and indirect cash ow statements differ in their presentation of cash ow from operations.

10.3
Year Ended December 31,
$ in millions

DIRECT METHOD
The direct method lists the separate sources of cash inow
and cash outow in operations in the following form:
Cash inows
Cash from sales
Cash from rents
Cash from royalties
Cash from interest received
Cash outows
Cash paid to suppliers
Cash paid to employees
Cash paid for other operating activities
Cash paid for interest
Cash paid for income taxes

The difference between cash inows and cash outows is


cash from operations.
The cash from operations section of the 2002 comparative
cash ow statement for Northrop Grumman Corp., the defense contractor, uses the direct method:

Operating Activities
Sources of cash
Cash received from customers
Progress payments
Other collections
Interest received
Income tax refunds received
Other cash receipts
Cash provided by operating activities
Uses of cash
Cash paid to suppliers and employees
Interest paid
Income taxes paid
Other cash payments
Cash used in operating activities
Net cash provided by operating activities

2001

2002

3,102
11,148
17
23
244
14,534

1,438
7,003
17
15
10
8,483

13,251
333
126
7
13,717
817

7,250
165
57
1
7,473
1,010

INDIRECT METHOD
The indirect method calculates cash from operations by subtracting accrual (noncash) components of net income:
Net income
Accruals
= Cash from operations
See Exhibit 10.1 for an example.
The indirect method has the feature of identifying the accruals made in calculating net income, and so it reconciles net
income to cash ow. But the direct method has the advantage
of listing the individual cash ows that generate the net cash,
so it is more informative about the sources of cash ows. (If
the direct method is used, a reconciliation of cash ow from
operations to net income must be supplied in footnotes.)
Almost all rms use the indirect method.

Change in Cash: Nike, Inc.


Nikes cash and cash equivalents increased by $194 million
in 2004. In the reformulated balance sheet in Exhibit 9.3
we attributed this to investment in cash equivalents (nancial assets) of $186 million and an increase in operating

1
cash of $8 million. So reclassify $8 million as cash investment in operations and $186 million as a debt nancing
ow for the purchase of nancial assets.

351

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

352 Part Two The Analysis of Financial Statements

EXHIBIT 10.1
GAAP Consolidated
Statements of Cash
Flows for Nike, Inc.,
20022004
Numbers on the righthand side ag the
adjustments numbered
in the text.

NIKE, INC.
GAAP Statement of Cash Flows
(in millions)

Year ended May 31


2004

2003

2002

$ 945.6

$ 474.0

$ 663.3 (3)(4)

252.1
19.0
58.3
47.2

266.1
239.3
55.0
23.2
12.5

5.0
223.5
15.9
48.1
13.9

82.5
(55.9)
(103.5)

(136.3)
(102.8)
60.9

(135.2)
55.4
16.9

269.1

30.1

175.4

1,514.4

922.0

1,082.2

Cash provided (used) by investing activities:


Purchases of short-term investments
Additions to property, plant, and equipment and other
Disposals of property, plant and equipment
Increase in other assets
(Decrease) increase in other liabilities
Acquisition of subsidiary, net of cash acquired

(400.8)
(213.9)
11.6
(53.4)
(0.9)
(289.1)

(185.9)
14.8
(46.3)
1.8

(2)
(282.8)
15.6
(28.7)
(6.9)

Cash used by investing activities

(946.5)

(215.6)

(302.8)

153.8

90.4

329.9

Cash provided (used) by operations:


Net income
Income charges not affecting cash:
Cumulative effect of accounting change
Depreciation
Deferred income taxes
Amortization and other
Income tax benet from exercise of stock options
Changes in certain working capital components:
Decrease (increase) in accounts receivable
(Increase) decrease in inventories
(Increase) decrease in prepaids and other current assets
Increase in accounts payable, accrued
liabilities, and income taxes payable
Cash provided by operations

Cash provided (used) by nancing activities:


Proceeds from long-term debt issuance
Reductions in long-term debt
including current portion
Decrease in notes payable
Proceeds from exercise of stock
options and other stock issuances
Repurchase of stock
Dividendscommon

(206.6)
(0.3)

(55.9)
(351.1)

(80.3)
(433.1)

253.6
(419.8)
(179.2)

44.2
(196.3)
(137.8)

59.5
(226.9)
(128.9)

Cash used by nancing activities


Effect of exchange rate changes

(398.5)
24.6

(606.5)
(41.4)

(479.8)
(28.1)

194.0
634.0
$ 828.0

58.5
575.5
$ 634.0

271.5 (1)
304.0
$ 575.5

$ 38.9
330.2

Net increase in cash and equivalents


Cash and equivalents, beginning of year
Cash and equivalents, end of year
Supplemental disclosure of cash ow information:
Cash paid during the year for:
Interest, net of capitalized interest
Income taxes

37.8
418.6

54.2 (3)(4)
262.0

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Chapter 10 The Analysis of the Cash Flow Statement 353

(over that needed for operations) in nancial assets that should be in the debt nancing
section.
2. Transactions in nancial assets. Investments in nancial assets such as short-term
marketable securities and long-term debt securities are included in the investments

Transactions on Financial Assets: Lucent Technologies


Lucent Technologies is the telecommunications network
supplier that was spun off from AT&T in 1996. The rm includes the research capabilities of the former Bell Laboratories. With the heavy network investment during the
telecom boom of the late 1990s, Lucent became a hot
stock, with its share price rising to $60 by late 1999,

yielding a P/E of 52. The rm was a darling of technology


analysts, but some were concerned about the rms declining cash ow from operations. Net income and cash
from operations are given below for the years 19971999,
along with the investment section of the rms cash ow
statement (in millions of dollars).
Fiscal Year Ending September 30
1999

Net income
Accruals
Cash from operating activities
Cash in investing activities:
Capital expenditures
Proceeds from the sale or disposal of property, plant, and equipment
Purchases of equity investments
Sales of equity investments
Purchases of investment securities
Sales or maturity of investment securities
Dispositions of businesses
Acquisitions of businessesnet of cash acquired
Cash from mergers
Other investing activitiesnet
Net cash used in investing activities

Despite increasing prots, free cash ow (the difference between cash from operating activities and cash
used in investing activities) appears to be negative in each
of the three years. This is not unusual if a rm is increasing its investment to generate prots. However, Lucent reported a shortfall of cash from operations, before investment, of $276 million in 1999 (the shortfall after adding
back after-tax net interest payments is $191 million). Cash
investment also declined in 1999, but the $1,787 million
number is misleading. This is the amount after selling
interest-bearing investments for $1,132 million, as you
see in the investing section of the statement. The net
proceeds from these investments, after purchases of
$450 million, is $682 million. So the actual investment in
operations was $1,787 + $682 = $2,469 million, not
$1,787 million, and the decits between reported cash

1998

$ 4,766
(5,042)
(276)

$ 1,035
825
1,860

(2,215)
97
(307)
156
(450)
1,132
72
(264)
61
(69)
(1,787)

(1,791)
57
(212)
71
(1,082)
686
329
(1,078)

(80)
(3,100)

1997
$

449
1,680
2,129
(1,744)
108
(149)
12
(483)
356
181
(1,584)

(68)
(3,371)

ow from operations and the actual investment in operations is a $2,745 million.


Free cash ow calculated from GAAP numbers can be
quite misleading. A rm like Lucent, faced with a cash
shortfall, can sell securities in which it is storing excess
cash to satisfy the shortfall. Under GAAP reporting, it
looks as if it is increasing free cash ow by doing so, making it look less serious than it is. GAAP reporting mixes the
cash ow decit with the means employed to deal with
the decit.
Postscript: Lucents negative cash ow in 1999 was an indicator
of things to follow. With the bursting of the telecom bubble,
Lucents share price declined to below $2 per share by 2003. The
rms accounting came into question. See Minicase M17.2 in
Chapter 17 where these same cash ow statements are investigated to raise accounting issues.

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

10. The Analysis of the


Cash Flow Statement

The McGrawHill
Companies, 2007

354 Part Two The Analysis of Financial Statements

section rather than in the nancing section in the GAAP statement. Nikes investment in
nancial assets of $400.8 million is agged in Exhibit 10.1. These investments are a disposition of free cash ow, not a reduction of free cash ow. If a rm invests its (surplus)
free cash ow from operations in nancial assets, the GAAP classication gives the appearance that the rm is reducing its free cash ow further. Similarly, sales of nancial
assets to provide cash for operations (or dividends) are classied in GAAP statements as
investment ows rather than nancing ows. These sales satisfy a free cash ow shortfall, they do not create it. Consequently, the GAAP statement can give the wrong impression of a rms liquidity. See the box in this section on Lucent Technologies.
3. Net cash interest. Cash interest payments and receipts for nancing activities are included in cash ow from operations rather than classied as a nancing ow. In Nikes
statement they are in cash ow from operations because they are in net income from
which the accruals are subtracted. See the accompanying box for some more extreme
examples.
An exception to including net interest in operations is interest capitalized during construction. This is classied, inappropriately, as cash investment because it is accounted
for as an investment in constructed assets (see the note on interest payments in Nikes
cash ow statement in Exhibit 10.1). But interest to nance construction projects is not
part of the cost of construction and should be classied as a nancing cash ow.
Unfortunately, disclosure is usually not sufcient to sort this out.

Interest Payments: Westinghouse


and Turner Broadcasting System
An extreme case of interest payments distorting cash ow
from operations appears in the 1991 cash ow statement
for Westinghouse. The reported cash ow was $703 million but that was after $1.006 billion of interest payments. If these interest payments had been classied as nancing outows, the cash ow from operations gure,
before tax, would have been $1.709 billion, or 243 percent higher.
The peculiarity of treating interest as an operating ow
can be seen in the case of zero coupon or deep discount
debt. The repayment of the principal at face value is a

nancing ow, but GAAP requires the difference between


face value and the issue amount (the issue discount) to be
treated as an operating cash ow at maturity rather than
part of the repayment of principal. So repayment of debt
reduces operating cash ow. Accordingly, in 1990 Turner
Broadcasting System deducted $206.1 million of issue discounts on zero coupon senior notes repaid in calculating
an operating cash ow of $25.8 million. This is correct accounting according to GAAP, but the reported operating
cash ow is an 89 percent distortion of the actual $231.9
million number.

4. Tax on net interest. Just as cash from interest income and expense is confused with operating cash ows, so are taxes paid on nancing and operating income. All tax cash
ows are included in cash from operations, even though some apply to nancial income
or are reduced by nancial expenses. We seek to separate after-tax operating cash ows
from after-tax nancing cash ows, but the GAAP statement blurs this distinction. The
accompanying box calculates Nikes after-tax net interest to adjust GAAP cash ow
from operations.

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

Chapter 10 The Analysis of the Cash Flow Statement 355

Taxes on Net Interest Payments: Nike, Inc.


Nikes 2004 net interest payments after tax are calculated
as follows (in millions of dollars):
Interest payments
Interest income
Net interest payments before tax
Tax benet (37.1%)
Net interest payments after tax

$ 37.8
(15.0)
22.8
8.5
14.3

The after-tax net interest of $14.3 million is added back


to cash from operations in the reformulated statement and
classied instead as a nancing payment to debtholders.
Note that interest payments, usually reported at the
foot of the cash ow statement, are not the same as
interest expense in the income statement (that includes
accruals).

Cash interest payments must be disclosed by rms in footnotes: Nikes disclosure of


its interest payments is found at the bottom of the cash ow statement in Exhibit 10.1.
Convert these interest payments to an after-tax basis at the marginal tax rate. Cash interest receipts are usually not reported. The accrual number in the income statement has
to be used for interest receipts; this number will equal the cash number only if the opening and closing interest accruals are the same.
5. Noncash transactions. Nike had no noncash transactions in 2004, but it did report noncash transactions in 2000. See the accompanying box. In a noncash transaction, an
asset is acquired or an expense is incurred by the rm by assuming a liability (by writing a note, for example) or by issuing stock. An acquisition of another rm for stock is
a noncash transaction. Capitalized leases are recorded as assets and liabilities, but there
is no cash ow for the purchase. A noncash transaction can involve an asset exchange
(one asset for another) or a liability exchange, or a conversion of debt to equity or vice
versa. With the exception of asset and liability exchanges within operating and nancing categories, these noncash transactions affect the Method 1 and Method 2 calculations of free cash ow because they affect NOA or NFO. Implicitly we interpret these as
if there were a sale of something for cash and an immediate purchase of something else
with that cash. The GAAP statement recognizes these transactions as not involving cash
ows. This of course is strictly correct but it obscures the investing and nancing activities, and the as-if cash ow accounting uncovers them. Consider the following
examples:
Debt that is converted to equity is not indicated as a payment of a loan (in the nancing section) in a GAAP statement even though the proceeds from the loan were
recorded there in an earlier year when the debt was issued.
If a rm acquires an asset by writing a note, the payment of the note is recorded in
subsequent years but the original principal that is being paid off is not.
For leases, nothing is recorded at the inception of the lease, but subsequent lease payments are divided between interest and principal repayments and recorded in the operating and nancing sections, respectively, in the GAAP statement. The rm appears
to be paying off a phantom loan.
For an installment purchase of plant assets, only the initial installment is classied as
investment. Subsequent payments are classied as nancing ows. However, when a
rm sells an asset, all installments are investing inows from the liquidation. Obtaining details is difcult.

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The upshot of all this is that we dont get a complete picture of rms investment and
nancing activities in the GAAP statement. In all cases of noncash transactions, the
as-if cash must be reported in supplemental disclosures so that implicit cash ows can
be reconstructed.

Noncash Transactions: Nike, Inc., 2000


At the foot of its 2000 statement of cash ows, Nike
reported the following (in millions):
Assumption of long-term debt to acquire property,
plant, and equipment
$108.9

This transaction was not incorporated in the GAAP cash


ow statement. To adjust the statement, add $108.9 million to cash investments and $108.9 million to issue of
debt in nancing activities.

Tying It Together
Box 10.4 summarizes the adjustments that must be made to the GAAP statement of cash
ows and makes the adjustment to Nikes statement. The numbers accompanying selected
items ag them as one of the ve adjustments above.
The free cash ow of $974 million in Nikes reformulated statement differs from the
$814 million calculated under Method 1 and Method 2 in Box 10.1. This often happens.
Because of incomplete disclosures, it is usually not possible to reconcile the cash ow
statement to the income statement and balance sheet precisely. The likely reasons for the
differences in the calculation are
Other assets and other liabilities cant be classied into operating and nancing
items appropriately. In particular, interest receivable and payable (nancing items) cannot be distinguished from operating items in these other categories.
Cash dividends (in the cash ow statement) differ from dividends in the statement of equity, implying a dividend payable that cannot be discovered, (usually lumped into other
liabilities).
Cash received in share issues (in the cash ow statement) differs from the amount for
those share transactions in the statement of equity, as with Nike. The difference implies
a receivable (for shares issued but not paid for) that has not been discovered.
The details for adjustments 3, 4, and 5 above are not available. Watch for acquisitions
with shares rather than cash.
When foreign subsidiaries are involved, balance sheet items are translated into dollar
amounts at beginning and end-of-year exchange rates while cash ow items are translated at average exchange rates. This results in a difference between the changes in balance sheet numbers and the corresponding items in the cash ow statement.
Cash ow from the tax benet received from issue of stock in response to exercise of
stock options is classied in the GAAP statement as cash from operations rather than a
nancing cash ow. This number is Nikes cash ow from operations explains $47 million of the difference we are looking for. Effective 2005, rms must report this cash ow
in nancing activities under GAAP.
The Method 1 and Method 2 calculations treat the cost of paying employees with shares
when they exercise their option as an as if cash ow: The difference between the
market price and exercise price of shares issued is effectively cash compensation, no

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Adjusting GAAP Statements of Cash Flows:


Summary and Example
REFORMULATING GAAP CASH
FLOW STATEMENTS
GAAP free cash ow
Increase in operating cash
+ Purchase of nancial assets
Sale of nancial assets
+ Net cash interest outow (after tax)
Noncash investments
= Free cash ow
GAAP nancing ow
+ Increase in cash equivalents
+ Purchase of nancial assets
Sale of nancial assets
+ Net cash interest outow (after tax)
Noncash nancing
= Financing cash ow

10.4

NIKE, INC.
Reformulated Cash Flow Statement, 2004
(in millions)
1
2
2
3,4
5

3,4

1
2
1
2
2
3,4
5

Free cash ow
Reported cash from operations
Net interest payment (after tax)
Cash investments reported
Investment in operating cash
Investment in nancial assets

$1,514
14
1,528
$ 947
8
(401)

Free cash ow

2
3,4
1

Financing ows to claimants


Debt nancing:
Issue of long-term debt
Reductions in long-term debt
Investment in nancial assets
Net interest payments (after tax)
Investments in cash equivalents
(net of exchange rate
effects on cash)
Equity nancing:
Share issues
Shares repurchase
Dividends
Total nancing ows

554
$ 974

(154)
207
401
14
161

(254)
420
179

629

345
$ 974

different from issuing shares to employees at the market price and giving them cash for
the difference. Strictly, there is no cash ow, and a credit analyst may treat it as such. But
the equity analyst understands that cash-equivalent value is given up in operations,
cash that the shareholders otherwise could have. Nikes loss for the exercise of options
in 2004 was $80 million. This, together with the $47 million of tax benet explains most
of the difference between the $974 million of free cash ow and the $814 million calculated in Box 10.1.
The reconciliation of the two numbers is not only relevant to getting a sound free cash
ow number. Any misclassication of operating and nancing assets and liabilities that
produces the difference also affects the calculation of operating protability (RNOA) and
net borrowing costs (NBC). So the exercise in calculating free cash ow using the different
methods serves as a validity check on the analysis of the income statement and balance
sheet. An error in reformatting the income statement or balance sheet produces a difference
in the two free cash ow calculations. And an error in reformulating the income statement
and balance sheet results in ratios (to be used in valuation) that are in error. So the analysis
here is a prerequisite to sound ratio analysis in Chapters 11 and 12.
But lets not miss the forest for the trees. Calculations aside, what is the picture drawn
here? Following the reformulated statement, Nike had a free cash ow from operations of
$974 million because cash investments were less than cash from operations. The rm used
357

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The Quality of the Cash Flow


from Operations Number
Commentators sometimes point to cash from operations as
a pristine number on which to judge the operating performance of a rm. But the fundamental analyst is cynical.

CASH FLOW AND NONCASH CHARGES


Cash ow from operations is often promoted as a better number than earnings on which to rely because it dismisses noncash charges like depreciation. Analysts often view those
charges as coming from bookkeeping rules that do not affect the cash generation. However, one ignores depreciation
to ones peril. Depreciation is not a cash ow in the period
when it is charged, but it certainly comes from cash outows,
made earlier, for investments. And those investments are necessary to generate cash from operations. If one refers to cash
ows rather than earnings, one should refer to net cash
owcash ow from operations less the cash invested to
deliver cash from operationswhich, of course, is free cash
ow.
In 2001, Electronic Data Systems Corporation (EDS), the
computer systems vendor, reported cash ow from operations
of $1,722 million. This was more than the $1,363 million reported in earnings. However, the cash ow number was the
result of adding back $1,482 million from earnings for depreciation of plant and amortization of software costs. Looking at
the investment section of the cash ow statement, the analyst
would nd that the current expenditure in plant and software
was $1,579 million. These expenditures were necessary to
maintain cash from operations in the future. Touting cash
from operations without considering the cash expenditures
(or depreciation) needed to maintain the cash from operations
gives a false impression of the ability of the rm to generate
cash from operations.

Delaying Payments
Firms can increase cash ow simply by delaying payments on
accounts payable and other operating obligations. The delay
does not affect earnings. Home Depot, the warehouse retailer, reported cash from operations of $5,942 million for scal year 2002, up from $2,977 million from the year earlier.
But $1,643 million of the amount reported in 2002 came
from an increase in accounts payable and taxes payable.

Advertising and R&D Expenditures


Because advertising and research and development expenditures are treated as cash from operations rather than cash
investment under GAAP, cash from operations can be in-

358

10.5

creased by reducing these expenditures (with adverse consequences for the future).

Advancing Payments of Receivables


Firms can increase cash ow by selling or securitizing receivables. This does not, however, represent an ability to generate
cash from sales of products. In 2001, TRW Inc. earnings
dropped to $68 million from $438 million in 2000 while operating cash ow increased by $338 million. Most of this increase was due to the rm selling receivables for $327 million.
(The rm disclosed this in footnotes.)

Noncash Transactions
Firms can increase cash from operations by paying for services
with debt or share issues. Deferring the payment of wages
with a payable or pension promise increases cash ow, as
does compensation paid with stock options rather than
cash.

Structured Finance
With the help of a friendly banker, rms might structure borrowing to make the cash ows received from the borrowing
look like operating cash ows rather than nancing cash
ows. Enron was a case in point: Funneled through an offbalance-sheet vehicle, loans were disguised as natural gas
trades between Enron and its bank and the cash receipts from
the effective loan were reported as cash from operations.

Capitalization Policy Affects Cash from Operations


If a cash outow is treated as an investment and thus capitalized on the balance sheet, it falls into the investment section
of the cash ow statement rather than the cash from operations sections. So, if a rm is aggressively capitalizing what
would otherwise be operating costs, it increases its cash ow
from operations. Routine maintenance costs may be treated
as property, plant, and equipment, for example.

Mismatching
The basic problem with cash ow from operations is that it
does not match inows and outows well. You see this in the
EDS example above. As another example, a rm making acquisitions increases cash ow from operations from new customers acquired. But the cost of acquiring those cash ows is
not in the cash ow section of the statement.

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this cash to pay out a net $629 million to debtholders and issuers and a net $345 million to
shareholders.

CASH FLOW FROM OPERATIONS


Our calculations following Methods 1 and 2 yield a number for free cash ow but do not
distinguish the two components, cash ow from operations and cash investments, in the free
cash ow number. For that we need the cash ow statement. But, again, we run into problems with the reporting. The reason is that some of the cash ows that we might view as investment ows are included in cash from operations in the GAAP statement. Investment in
research and development is part of cash from operations rather than part of the investment
section. And investments in short-term assets are classied as cash from operations. Consider inventories. Investments in inventory are necessary to carry out operations just like
plant and equipment. But the cash spent on building up inventory reduces GAAP cash from
operations just like cash spent in inventory that is shipped to customers.
Potentially we could make further adjustments to cash ow from operations for these investments. But that should be done only if there is a clear purpose. For many analysis tasks,
it is free cash ow that is needed, and a misclassication of an investment as an operating
rather than investment ow does not affect this number. Because expenditures on R&D activities, a long-run investment, are classied as a decrease in cash from operations in nancial statements, the R&D expenditures are added back to calculate the appropriate cash
from operations. But the misclassication does not affect the calculation of free cash ow
from the statement. The treatment of investment in brand name through advertising, which
also reduces GAAP cash ow from operations, is similar.
Cash ow from operations is best seen as a diagnotic to challenge the quality of accrual
accounting. We will do this in Chapter 17. But the analyst must handle the cash ow from
operations number carefully. See Box 10.5.

Summary

The analyst looks to the cash ow statement to assess the ability of the rm to generate
cash. Free cash ow is a particular focus, for free cash ow is necessary to anticipate liquidity and nancing requirements in the future. And free cash ow forecasts are required if
the analyst employs discounted cash ow methods for valuation. Subsequent chapters that
involve forecasting cash will rely on the analysis of this chapter.
Unfortunately, the GAAP statement of cash ows is a little messy. But, having reformulated income statements and balance sheets appropriately, free cash ow can be calculated
simply by Methods 1 and 2 laid out in this chapter. So we will see in the forecasting part of
the book that once forecasted (reformulated) income statements and balance sheets are prepared, forecasting free cash ow involves one simple calculation from these statements. It
is hard to think of forecasting free cash ow without thinking of future sales, protability,
and investments that will be reported in the income statement and balance sheet, so
forecasting these statements is needed to forecast free cash ow. And if those statements
are in reformulated form, the forecasted free cash ow drops out of them immediately. This
is a very efcient way of proceeding.
This chapter has presented the adjustments that are necessary to read the free cash ow
from the GAAP statement of cash ows. These adjustments reformulate the statement to
categorize cash ows correctly, so that free cash ow is isolated and shown to be equal to
the nancing ows.

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The Web Connection


Find the following on the Web page for this chapter:
Further examples of reformulated statements.
Further discussion of problems raised by the GAAP
presentation of the cash ow statement.

Key Concepts

Further illustration of adjustments to GAAP cash ow


statements.
Presentation of the cash ow statement under international accounting standards.

nancial planning is planning to arrange


nancing to meet the future cash ow
needs of the business. 346
liquidity analysis is the analysis of current
and future cash relative to the claims on
cash. 346

noncash transaction involves the


acquisition of an asset or the incurring
of an expense by assuming a liability
or by issuing stock, without any cash
involved. 355

The Analysts Toolkit


Analysis Tools

Page

Method 1 for calculating free cash ow


(equation 10.1)
Method 2 for calculating free cash ow
(equation 10.2)
Direct method for cash ow from operations
Indirect method for cash ow from operations
Reformulated cash ow statements

348
348
351
351
357

Key Measures

Page

Cash ow from operations


Cash ow in nancing activities
Cash ow in investing activities
Free cash ow
Net cash interest
Tax on net interest

349
349
349
347
354
354

A Continuing Case: Kimberly-Clark Corporation


A Self-Study Exercise
With the equity statement, the balance sheet, and the income statement reformulated in
the Continuing Case for Chapters 8 and 9, all that remains is to reformulate the cash ow
statement.

FREE CASH FLOW FROM BALANCE SHEETS


AND INCOME STATEMENT
Before reformulating the cash ow statement, calculate free cash ow for 2003 and 2004
from the balance sheets and comprehensive income statements you reformulated in the last
chapter. Apply Method 1 and Method 2.

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REFORMULATE THE CASH FLOW STATEMENT


Now reformulate the cash ow statement for 2004. The work you did in Chapter 4 will take
you part way. Note the information given there on interest paid during 2004 and the tax rate.
The number for free cash ow that you get from the reformulated cash ow statement
will differ from that which you obtained from the balance sheets and income statement.
Why might this be? Search the 10-K for likely explanations.
State in a few sentences what the reformulated cash ow statement is saying. Whats the
basic message?

Concept
Questions

C10.1.
C10.2.
C10.3.
C10.4.

C10.5.
C10.6.
C10.7.
C10.8.
C10.9.
C10.10.

Exercises

Why might cash ow analysis be important for valuing rms?


For what purposes might forecasting cash ows be an analysis tool?
For a pure equity rm (with no net debt), how is free cash ow disposed of ?
By investing in short-term securities to absorb excess cash, a rm reduces its cash
ow after investing activities in its published cash ow statement. What is wrong
with this picture?
Do you consider the direct method to be more informative than the indirect
method of presenting cash ow from operations?
GAAP cash ow statements treat interest capitalized during construction as investment in plant. Do you agree with this practice?
Why is free cash ow sometimes referred to as a liquidation concept?
Why might an analyst not put much weight on a rms current free cash ow as an
indication of future free cash ow?
What factors produce growth in free cash ow?
Consider the following quote from the CFO of Lear Corp. (in The Wall Street
Journal, May 8, 2002, p. C1), Sales of receivables and operating cash ows are
entirely separate events. We see sales of receivables as a low-cost nancing
method; it shouldnt generate operating cash ow. Do you agree?

Drill Exercises
E10.1.

Classication of Cash Flows (Easy)


State whether the following transactions affect cash ow from operations, free cash ow,
nancing ows, or none of them.
a. Payment of a receivable by a customer
b. Sale to a customer on credit
c. Expenditure on plant
d. Expenditure on research and development
e. Payment of interest
f. Purchase of a short-term investment with excess cash
g. Sale of accounts receivable

E10.2.

Calculation of Free Cash Flow from the Balance Sheet and


Income Statement (Easy)
A rm reported comprehensive income of $376 million for 2006, consisting of
$500 million in operating income (after tax) less $124 million of net nancial expense

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(after tax). It also reported the following comparative balance sheet (in millions of
dollars):
Balance Sheet

Operating cash
Short-term investments (at market)
Accounts receivable
Inventory
Property and plant

2006

2005

60
550
940
910
2,840
5,300

50
500
790
840
2,710
4,890

2006

2005

Accounts payable
Accrued liabilities
Long-term debt

1,200
390
1,840

1,040
450
1,970

Common equity

1,870
5,300

1,430
4,890

Calculate free cash ow using Method 1 and Method 2.


E10.3.

Analyzing Cash Flows (Medium)


Consider the following comparative balance sheets for the Liquidity Company:
December 31
2007
Operating cash
Accounts receivable
Inventories
Land (unamortized cost)
Plant assets
Less: accumulated depreciation
Accounts payable
Capital stock

$ 435,000
40,000
100,000
400,000
200,000
(100,000)
1,075,000
25,000
1,050,000
$1,075,000

2006
$

50,000
-0-0800,000
200,000
-01,050,000
-01,050,000
$1,050,000

The company paid a dividend of $150,000 during 2007 and there were no equity contributions or stock repurchases.
a. Calculate free cash ow generated during 2007.
b. Where did the increase in cash come from?
c. How would your calculation in part (a) change if the rm invested in short-term
deposits rather than paying a dividend?
E10.4.

Free Cash Flow for a Pure Equity Firm (Easy)


The following information is from the nancial report of a pure equity company (one with
no net debt). In millions of dollars.
Common shareholders equity, December 31, 2005
Common dividends, paid December 2006
Issue of common shares on December 31, 2006
Common shareholders equity, December 31, 2006

The rm had no share repurchases during 2006.


Calculate the rms free cash ow for 2006.

174.8
8.3
34.4
226.2

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E10.5.

Free Cash Flow for a Net Debtor (Easy)


The following information is for a rm that has net debt on its balance sheet. (in millions
of dollars).
Common shareholders equity, December 31, 2005
Common dividends, paid December 2006
Issue of common shares, December 2006
Common shareholders equity, December 31, 2006
Net debt, December 31, 2006
Net debt, December 31, 2006

174.8
8.3
34.4
226.2
54.3
37.4

There were no share repurchases during 2006. The rm reported net interest after tax of
$4 million on its income statement for 2006, and this interest was paid in cash.
Calculate the rms free cash ow for 2006.
E10.6.

Applying Cash Flow Relations (Easy)


A rm reported free cash ow of $430 million and operating income of $390 million.
a. By how much did its net operating assets change during the period?
b. The rm invested $29 million cash in new operating assets during the period. What
were its operating accruals?
c. The rm incurred net nancial expenses of $43 million after tax, paid a dividend of
$20 million, and raised $33 million from share issues. What was the change in its net
debt position during the period?

E10.7.

Applying Cash Flow Relations (Medium)


An analyst prepared reformulated balance sheets for the years 2007 and 2006 as follows (in
millions of dollars):

Operating assets
Financial assets
Financial debt
Operating liabilities
Common equity

2007

2006

$640
250
890
170
20
700
$890

$590
110
700
130
30
540
$700

The rm reported $100 million in comprehensive income for 2007 and no net nancial
income or expense.
a. Calculate the free cash ow for 2007.
b. How was the free cash ow disposed of ?
c. How can a rm with nancial assets and nancial liabilities have zero net nancial
income or expense?

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E10.8.

Calculating Free Cash Flow under Alternative Circumstances (Medium)


(Exercise supplied by James Ohlson, Arizona State University)
a. Consider the following balance sheet information (in millions of dollars):

Operating assets
Operating liabilities
Common stock
Retained earnings
Treasury stock

2006

2005

115,000
50,000
30,000
48,000
(13,000)
115,000

90,000
41,000
30,000
29,000
(10,000)
90,000

The company follows the following nancing policy: If the business operations generate positive cash ows, then the company buys back its own stock; if the cash ows are
negative, then the company sells stock. There are never any interest-incurring debts,
regular cash dividends, or investments in passive marketable securities.
Determine the rms free cash ow for 2006.
b. Consider the following balance sheet information (in millions of dollars):

Operating assets
Operating liabilities
Bonds payable, 6%
Common stock
Retained earnings

2006

2005

115,000
50,000
8,000
30,000
27,000
115,000

90,000
41,000
12,000
30,000
7,000
90,000

This rms tax rate is 35 percent.


The company follows the following nancial policy: If the business operations generate positive cash ows, after interest expense, then the company pays down its debt. If
the operations generate negative cash ows, the company borrows. The company does
not engage in treasury stock transactions, pay regular dividends, or invest in passive
marketable securities.
Determine the rms free cash ow for 2006, which must be before interest expense
(after tax). The average debt was $10,000 million during 2006.
c. Consider the following balance sheet information (in millions of dollars):

Financial assets
Operating assets
Operating liabilities
Common stock
Retained earnings
Accumulated unrealized gains
on nancial assets

2006

2005

12,000
115,000
127,000
47,500
30,000
48,000

8,000
90,000
98,000
36,500
30,000
29,000

1,500
127,000

2,500
98,000

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The company relies on the following nancial policy: If the business operations generate positive cash ows, the company buys nancial assets (marketable securities). If
the operations generate negative cash ows, the company sells nancial assets (marketable securities). Interest revenue earned during the current year amounted to $300
million. There were no realized gains or losses related to marketable securities. There
are no dividends.
Determine the rms free cash ow for 2006, which must exclude interest revenue
(after tax).
Applications
E10.9.

Free Cash Flow and Financing Activities: General Electric Company (Easy)
The following summarizes free cash ows generated by General Electric from 20002004
(in millions of dollars).

Cash from operations


Cash investments
Free cash ow

2000

2001

2002

2003

2004

30,009
37,699
(7,690)

39,398
40,308
(910)

34,848
61,227
(26,379)

36,102
21,843
14,259

36,484
38,414
(1,930)

a. Explain why such a protable rm as General Electric can have negative free cash ow.
b. In 2005, the rm announced that the years of building its set of businesses was largely
behind it, so it would be slowing its investment activity. What is the likely affect on
free cash ow? How will GEs nancing activities likely change? What are the alternative nancing alternatives in light of the changed free cash ow?
E10.10.

Extracting Information from the Cash Flow Statement with a Reformulation:


Microsoft Corporation (Medium)
For many years, Microsoft has generated considerable free cash ow. Up to 2004, it paid no
dividends and had no debt to pay off, so it invested the cash in interest bearing securities.
Its balance sheet at the end of its second (December) quarter for scal year ending
June 2005 reported the following among current assets (in millions):

Cash and equivalents


Short-term investments

June 30, 2004

December 31, 2004

$ 15,982
44,610

$ 4,556
29,948

You can see a signicant reduction in both cash and short-term investments. During the
second quarter, Microsoft decided to pay its rst dividend in the form of a large special dividend. Exhibit 10.2 gives the cash ow statement for the quarter, along with a note on interest received on the investments listed above. The rms tax rate is 37.5 percent.
Answer the following questions about the quarter ended December 31, 2004:
a. What were the cash dividends paid to common shareholders?
b. What was the net dividend paid out to shareholders?
c. Calculate (unlevered) cash ow from operations for the quarter.
d. Calculate cash invested in operations.
e. Calculate free cash ow.
f. Why was the net cash from investing number reported for 2004 so different from that
for 2003? Is the large difference due to a change in Microsofts investment in its
operations?

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g. Microsoft maintains $60 million in operating cash. What was its net investment in nancial assets during the quarter (before any effect of exchange rates)?
After answering these questions, you have the ingredients to construct a reformulated cash
ow statement. Go ahead and do it.
Real World Connection
Exercises on Microsoft are E1.6, E4.16, and E17.10. Minicases M8.2 and M12.1 also deal
with Microsoft.
EXHIBIT 10.2
Cash Flow Statement
for Microsoft
Corporation for
Fiscal Second
Quarter, 2005

Cash Flow Statements


(In millions, unaudited)

Three Months Ended


December 31

Operations
Net income
Depreciation and amortization
Stock-based compensation
Net recognized (gains)/losses on investments
Stock option income tax benets
Deferred income taxes
Unearned revenue
Recognition of unearned revenue
Accounts receivable
Other current assets
Other long-term assets
Other current liabilities
Other long-term liabilities
Net cash from operations
Financing
Common stock issued
Common stock repurchased
Common dividends
Net cash from nancing
Investing
Additions to property and plant
Acquisition of companies net of cash acquired
Purchases of investments
Maturities of investments
Sales of investments
Net cash from investing
Net change in cash and equivalents
Effect of exchange rates on cash and equivalents
Cash and equivalents, beginning of period
Cash and equivalents, end of period

2003

2004

$ 1,549
300
3,232
(321)
148
(985)
2,774
(3,166)
(1,004)
607
55
1,256
129
4,574

$ 3,463
108
551
74
99
68
3,354
(3,166)
(1,398)
373
7
17
69
3,619

189
(730)
(1,729)
(2,270)

795
(969)
(33,498)
(33,672)

(172)

(22,377)
825
19,775
(1,949)
355
26
5,768
$ 6,149

(176)
(1)
(16,013)
19,536
20,068
23,414
(6,639)
54
11,141
$ 4,556

Note: Interest
Microsoft has no debt, so paid no interest during the three months. Interest received from
investments was $378 million.

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

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Companies, 2007

10. The Analysis of the


Cash Flow Statement

Chapter 10 The Analysis of the Cash Flow Statement 367

E10.11.

Analyzing a Change in Free Cash Flow: Wal-Mart Stores (Medium)


The excerpts from Wal-Marts cash ow statements below show that reported free cash
ow increased from a decit of $949 million in 1996 to a surplus of $3,862 million in 1997.
Yet net income increased by only $316 million.
Fiscal Years Ended January 31
(Amounts in millions)
Cash Flows from Operating Activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation and amortization
Increase in accounts receivable
Increase/decrease in inventories
Increase in accounts payable
Increase in accrued liabilities
Deferred income taxes
Other
Net cash provided by operating activities
Cash Flows from Investing Activities
Payments for property, plant, and equipment
Proceeds from sale of photo nishing plants
Other investing activities
Net cash used in investing activities

1997

1996

$ 3,056

$ 2,740

1,463
(58)
99
1,208
430
(180)
(88)
5,930

1,304
(61)
(1,850)
448
29
76
(303)
2,383

(2,643)
464
111
(2,068)

(3,566)
234
(3,332)

Explain the change in reported free cash ow from 1996 to 1997.


Real World Connection
See Exercises E4.11 and E14.13 on Wal-Mart Stores.
E10.12.

Analysis of Protability and Cash Flows: Quantum Corporation (Medium)


Quantum Corporation is a leading supplier of hard disk drives for personal computers,
notebook computers, and workstations and a manufacturer of tape storage devices.
Below are balance sheets and income statements for Quantum Corporation that have
been reformulated to place them on a comprehensive income basis and to distinguish operating and nancing activities. Amounts are in millions of dollars.
a. Compare the operating and nancing protability from 1994 to 1996.
b. Calculate free cash ow for 1994, 1995, and 1996. Explain the changes in free cash
ow.
c. Explain how the rm went from a net creditor position to a net debtor position from
1994 to 1996.

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

The McGrawHill
Companies, 2007

10. The Analysis of the


Cash Flow Statement

368 Part Two The Analysis of Financial Statements

QUANTUM CORPORATION
Balance Sheets

Net Operating Assets


Accounts receivable, net of doubtful
accounts
Inventories
Deferred taxes
Other current assets
Net property, plant, and equipment
Purchased intangibles
Other assets
Accounts payable
Accrued warranty expense
Accrued compensation
Income taxes payable
Accrued exit and restructuring costs
Other accrued liabilities
Net operating assets
Net Financial Obligations
Cash and cash equivalents
Marketable securities
Short-term debt
Subordinated debentures
Long-term debt
Net nancial obligations
Common Shareholders Equity

1993

1994

1995

1996

$266,992
223,107
37,479
13,094
74,698

19,034
(215,909)
(42,410)
(17,189)
(19,020)

(21,825)
318,051

$324,376
194,083
32,821
14,365
85,874
1,295
14,585
(267,189)
(55,617)
(15,315)

(35,545)
293,733

$497,887
324,650
44,054
35,580
280,099
95,818
15,187
(355,117)
(57,001)
(54,917)
(17,566)
(32,213)
(77,227)
699,234

$711,107
459,538
109,625
81,472
364,111
66,313
18,437
(498,829)
(62,289)

(11,232)
(103,165)
(152,734)
982,354

(121,898)
(170,751)

212,500

(80,149)
$398,200

(217,531)
(112,508)

212,500

(117,539)
$411,272

(187,753)

50,000
212,500
115,000
189,747
$509,487

(164,752)

4,125
374,283
223,875
437,531
$544,823

Income Statements

Core Operating Income


Sales
Cost of sales
Operating expenses
Research and development
Sales and marketing
General and administrative
Operating costs and expenses
Operating income
Tax on core income
Core operating income, after tax
Unusual Operating Income
Operating income
Net Financial Expenses
Net income available in common

Real World Connection


See Exercise E12.8 in Chapter 12.

1993

1994

1995

1996

$ 1,697,240
(1,374,422)

$ 2,131,054
(1,892,211)

$ 3,367,984
(2,804,271)

$ 4,422,726
(3,880,309)

(63,019)
(77,085)
(33,849)
(173,953)
148,865
(53,408)
95,457

95,457
(1,646)
$
93,811

(89,837)
(74,015)
(41,910)
(205,762)
33,081
(9,226)
23,855
(16,382)
7,473
(4,799)
$
2,674

(169,282)
(108,290)
(52,134)
(329,706)
234,007
(88,551)
145,456
(52,520)
92,936
(11,345)
$
81,591

(239,116)
(142,413)
(65,145)
(446,674)
95,743
(15,501)
80,242
(150,568)
(70,326)
(20,130)
$ (90,456)

Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition

II. The Analysis of


Financial Statements

10. The Analysis of the


Cash Flow Statement

The McGrawHill
Companies, 2007

Chapter 10 The Analysis of the Cash Flow Statement 369

Minicase

M10.1

Analysis of Cash Flows: Dell, Inc.


Dell, Inc. has been a very successful company, generating considerable cash ow from
operations. Dells scal 2002 nancial statements are given in Exhibit 2.1 of Chapter 2.
A. Reformulate the income statement and balance sheets to highlight the operating and nancing activities, and calculate free cash ow from these statements. Compare this calculation to free cash ow calculated directly from the cash ow statement. Note, for
your calculation, that Dells marketable securities are substantially all debt securities
and Dells marginal tax rate is 35 percent. Can you speculate as to the reason for any discrepancies between the two calculations?
B. In 1999 Dell began to report the cash benet of taxes saved from employee stock option
plans as part of cash ow from operations. Previously these tax benets had been reported as part of nancing cash ows.
What do you consider to be the appropriate classication of tax benets from employee stock plans?
How does Dells classication affect the reconciliation of the two cash ow numbers
in question (A)?
C. Dell reports cash proceeds from the issue of common stock of $295 million in its 2002
cash ow statement. Yet it reports $853 million from the issue of stocks in its 2002 statement of shareholders equity. Can you reconcile the two numbers?
D. Dell holds considerable nancial assets. What alternatives are open to Dell for the use
of the cash pile?

Real World Connection


Dell is analyzed further in Exercises E1.4, Exhibit 2.1, E4.8, E4.9, E8.10, E13.14, and also
in Minicase M15.1. See also Boxes 4.5 and 4.6 in Chapter 4 and Box 11.5 in Chapter 11 for
further coverage of Dell.