Free Cash Flow, the Cash Flow Identity, And

the Accounting Statement of Cash Flows

J. William Petty and John T. Rose

Baylor University

This study highlights the relationship between the two major tools of cash flow
analysis, namely, free cash flow within the cash flow identity and the accounting
statement of cash flows. After reviewing current textbook pedagogy for
introducing the concept of a firm's cash flow, we derive the accounting statement
of cash flows from the cash flow identity (in which a firm's free cash flow equals
its cash flow to investors). Using a numeric example, we also compare the
information generated by the two analytical tools, noting both the difference in
focus between the tools as well as the differences in construction. Finally, we
encourage textbook authors to give greater attention to the linkage between free
cash flow within the cash flow identity and the accounting statement of cash
flows, as well as the importance of free cash flow for financial management.

INTRODUCTION

One of the major topics commonly covered in the early weeks of an introductory course in
financial management pertains to a firm's cash flow. The purpose of such coverage is threefold.
First, it is important for students to understand the difference between net income and cash flow
and to recognize that cash flow trumps net income in assessing a firm's financial performance
or, as some finance textbooks state, "cash is king." Second, understanding the importance ofa
firm's cash flow sets the stage for later discussing the valuation of bonds, stocks, capital
investment projects, and even the firm itself, all of which involve discounted cash flow
analysis. Finally, a firm's cash flow, specifically, its free cash flow, has implications for the
agency relationship between the firm's owners and its managers, which, too, is typically
discussed early on in the course.
Introductory finance textbooks differ, however, in the analytical tool(s) they use to
introduce the concept of a firm's cash flow, as some textbooks focus on the concept of free cash
flow while others emphasize the accounting statement of cash flows. Thus, unless an instructor
presents both tools, students may not be aware of the alternative tool. This can be particularly
vexing for students who are exposed only to free cash flow since they will normally see the
accounting statement of cash flows, rather than free cash flow, in the business world. And even
if both analytical tools are discussed, as some

Fall 2009 41
books do, studentS may not fully understand the linkage between them, since none of the texts of
which we are aware sufficiently reconciles the tools. The purpose of this study, therefore, is 1) to
review current textbook pedagogy for introducing the concept of a firm's cash flow, 2) to
highlight the relationship between free cash flow within the cash flow identity and the
accounting statement of cash flows, and 3) to encourage textbook authors to give greater
attention to the linkage between the free cash flow concept and the accounting statement of cash
flows, as well as the importance of free cash flow for
financial management.

The next section discusses the reasons for addressing the concept of cash flow in the
introductory finance course and current pedagogy for teaching cash flow, as presented in
introductory financial management textbooks. The third section uses algebraic formulation to
derive the accounting statement of cash flows from the cash flow identity, which presents free
cash flow on the left-hand side of the identity and cash flow to investors on the right-hand side.
That is followed by a numeric example showing the construction of 1) free cash flow within the
cash flow identity and 2) the accounting statement of cash flows, using financial statement
information from a hypothetical firm, along with a discussion of the differences in focus and
construction of these two
analytical tools. The last section is a summary and conclusion.

TEXTBOOK APPROACHES FOR INTRODUCING A FIRM'S CASH FLOW

Introductory financial management textbooks differ in the analytical tools they use to introduce
the concept of a firm's cash flow. One group of books takes a distinctly finance-oriented
approach consistent with the separation of the investment and financing decisions by
emphasizing the cash flow produced by the firm's assets, commonly termed "free cash flow"; see,
for example, Keown et aJ. [20071 and Ross et al. [20081. Free cash flow gives the net cash flow
available for distribution to investors (debtholders and stockholders) after the firm has met all of
its operating needs and paid for investments in new fixed assets and net working capital.' In fact,
both Keown et aJ. [20071 and Ross et al. [20081 carry the free cash flow approach to the point of
showing the equality of free cash flow with the firm's cash flows to investors in what Ross et al.
[20081 terms the "cash flow identity.,,2
There are several reasons for focusing on free cash flow in the introductory finance
course. First, as presented within the cash flow identity, free cash flow provides students with a
global picture of a firm's cash flows by showing that the total cash flow from the firm's assets (net
of any cash outflows for investments in new capital assets and net working capital) must
necessarily equal the total cash flow to the firm's investors. Second, discounted free cash flow
analysis provides an alternative to the dividend growth model for valuing a fum, as discussed in
Brigham and Houston [20071, Gitman [20061, Keown et al. [20071, and Moyer et sl. [20061.
Finally, as noted in Jensen [1986, 19891 and referenced in Aug's [19911 discussion of corporate
slack, free cash flow adds to the agency conflict between a firm's owners and its managers, which
is typically discussed at the

42 Journal of Financial Education

 outset of the introductory finance course in the context of the goal of financial management. The
reason for this additional agency conflict is that free cash flow available after investment in positive
NPV projects, particularly in low-growth or declining firms with limited attractive investment
opportunities, gives financial managers the opportunity to waste resources through organizational
slack or investment in unsound (negative NPV) projects. In that context, debt creation (financial
leverage) may serve to mitigate the agency problem of free cash flow by committing future cash
flows to debt service and so reducing the cash flow available to managers for discretionary spending.
A second group of texts either ignores or barely mentions the concept of free cash flow and
instead focuses on the accounting statement of cash flows [F ASB, 1987]. The accounting statement
of cash flows shows the net effect of cash flows from operating activities, investment activities, and
financing activities on the firm's cash account (cash & equivalents on the balance sheet); see, for
example, Brealey et sl. [2004] and Moyer et a1 [' 006]3 Thus, in contrast with the textbooks that
emphasize a firm's free cash flow, texts that focus on the accounting statement of cash flows do so to
show how the different sources and uses of cash factor into a change in the firm's cash account.
Finally, a third group of textbooks highlights both a firm's free cash flow and the accounting
statement of cash flows; see Block and Hirt [2008], Brigham and Houston [2007], Gitman [2006],
and Megginson and Smart [2006].4
It should be noted that free cash flow, as commonly defined in finance textbooks and as we
define it later, is not necessarily discretionary cash flow since the firm may have legal and/or
expected commitments in terms of interest expense, preferred and common stock dividends, and
retirement of debt that it must honor from its free cash flow. Accordingly, Block and Hirt [2008]
amends the standard textbook definition offree cash flow by subtracting dividends that must "be paid
to keep shareholders satisfied," arguing that "the balance, free cash flow, is then available for special
financing activities." Similarly, Moyer et a1 [2006], in a discussion of discounted free cash flow
analysis later in the text, subtracts some payments to investors, such as interest expense, preferred
and even some common stock dividends, and required redemption of debt and preferred stock,
leaving a residual available to service additionaldebt, pay additional dividends, buy back stock, or
make additionalinvestments. Most textbooks, however, do not make any such adjustments,
implicitly assuming that the reader should understand that some portion of free cash flow may be
dedicated to legal and/or expected commitments'
Even if a financial management textbook ignores or gives only minimal attention to the concept
of free cash flow in the initial discussion of a firm's cash flow, every finance textbook employs a
variation of free cash flow later in the text in estimating the expected cash flows from a capital
investment project, although books typically do not use the "free cash flow" term in this context.
Additionally, Brealey et a1 [2004] and Megginson and Smart [2006] address the free cash flow
motive for takeover mergers, drawing on the work of Jensen [1986, 1989]. As noted earlier, Jensen
[1986,1989] highlights the agency costs of free cash flow and the resulting incentive for corporate
takeovers by mature

'o Fall 2009 43

n
firms with a surplus of cash, even though such takeovers may not be economically sound
investments. Interestingly, however, Brealey et a1. [2004] fails to explore the concept of free cash
flow in the text's initial discussion of a firm's cash flow, focusing instead on the
accounting statement of cash flows.
Generally missing from these textbook discussions, however, is any attempt to
reconcile a firm's free cash flow with the accounting statement of cash flows. A partial exception is
Block and Hirt [2008], which defines free cash flow as a "by-product" of the accounting statement of
cash flows. However, even Block and Hirt [2008] falls short of fully reconciling free cash flow with
the accounting statement of cash flows since they do not explicitly tie a firm's free cash flow to its
cash flow to i.nvestors. Thus, even if students are introduced to both analytical tools, they may not
readily comprehend the linkage between these tools and how they relate to each other.
In fact, free cash flow, taken alone, cannot be fully reconciled with the accounting
statement of cash flows since free cash flow gives only the cash flow produced by the firm's assets
without any information as to the amounts of cash distributed to the different investor groups. Yet
those latter cash flows are incorporated into the accounting statement of cash flows either as part of the
firm's cash flow from operating activities (in the case of interest expense) or as part of the firm's cash
flow from financing activities. In that regard, Kousenidis [2006] seeks 1) to modify the accounting
statement of cash flows to link the cash flows from operating and investment activities (from the cash
flow statement) with a firm's free cash flow and 2) to show the equality of such free cash flow with the
cash flows received by debt and equity holders, i.e., the cash flow identity. Unfortunately, Kousenidis'
presentation of the linkage between a firms' free cash flow and the cash flows from operating and
investment activities is confusing (and certainly would be so to students), and the cash flow identity is
never really developed.I Thus, in this paper we tie together free cash flow and the accounting
statement of cash flows by expanding the discussion to link a firm's free cash flow with its cash flow to
investors
through the cash flow identity.

THE RELATIONSHIP BETWEEN FREE CASH FLOW WITHIN THE CASH FLOW
IDENTITY AND THE ACCOUNTING STATEMENT OF CASH FLOWS

To see the relationship between free cash flow within the cash flow identity and the accounting
statement of cash flows, we derive the accounting statement of cash flows (constructed here using the
indirect rnethod) from the cash flow identity as defined in Keown et a1. [2007] and Ross et a1.
[2008], i.e.,

Free cash flow = Cash flow to investors, (eq. 1)

where
Free cash flow = Opera6ng cash flow - tJGross fixed assets
_ tJNet workjng capjtal,8 and

44 Journal of Financial

Fa1l2009
Education
 Cash flow to investors = Cash flow to debtholders + Cash flow to stockholders.

Eq. 1 can thus be expanded to

Operating cash flow - LlGross fixed assets - LlNet working capital = Cash
flow to debtholders + Cash flow to stockholders, (eq.2)
where

Operating cash flow = EBIT - Taxes + Depreciation expense,

,1 Net working capital = ,1Cash + Mccounts receivable + LlInventories 9
- Mccounts payable,
10
Cash flow to debtholders = Interest expense - LlDebt, and
Cash flow to stockholders = Dividends paid - LlCommon stock.

Expanding eq. 2 further gives

EBIT - Taxes + Depreciation expense - LlGross fixed assets - [LlCash

+ ,1 Accounts receivable + ,11 nventories - ,1 Accounts payable) =
Interest expense - LlDebt + Dividends paid - LlCommon stock. (eq. 3)

which can be rearranged as

EBIT + Depreciation expense - Interest expense - Taxes

- ,1 Accounts receivable - LlInventories + ,1 Accounts payable
- LlGross fixed assets + LlDebt - Dividends paid + ,1 Common stock
= ,1 Cash. (eq.4)

Since Net income = EBIT - Interest expense Taxes, eq. 4 can be written as
V

Net income + Depreciation expense - Mccounts receivable

- Alnventories + ,1Accounts payable - LlGross fixed assets
+ LlDebt - Dividends paid + LlCommon stock = ,1Cash. (eq.5)

Finally, if we define

Cash flow from operating activities = Net income + Depreciation expense -

Mccounts receivable - Alnventories + Mccounts payable, Cash flow from
investment activities = LlGross fixed assets, and
Cash flow from financing activities = LlDebt - Dividends paid + LlCommon stock.

as is done in the accounting statement of cash flows, then

Fall 2009 45
 Cash flow from operating activities - Cash flow from investment activities
- Cash flow from financing activities = iJCash, (eq.6)

which is the format of the accounting statement of cash flows.

In sum, the cash flow identity (eq. 1), of which the left-hand side is the common definition
of free cash flow and the right-hand side is cash flow to investors, and the accounting statement
of cash flows (eq. 6) are essentially "two sides of the same coin." Both analytical tools make use
of the full array of a firm's cash flows, and each can be derived from the other.

A NUMERIC EXAMPLE

As an example of the relationships between free cash flow within the cash flow identity and
the accounting statement of cash flows, consider the financial statements of Seward
Manufacturing Co. shown in Figure 1 (balance sheets for year-end 2006 and 2007) and Figure 2
(income statement for 2007). Based on these financial statements we can construct Seward's
2007 cash flow identity and the firm's 2007 accounting statement of cash flows (indirect
method), presented in Figures 3 and 4, respectively.
As shown, both the cash flow identity and the accounting statement of cash flows present
the same cash flow information but organized differently. The cash flow identity divides a firm's
cash flows into two areas-free cash flow and cash flow to investors-which must necessarily
equal each other. As such, the cash flow identity gives a global picture of a firm's cash flows,
reflecting the finance perspective of viewing the investment cash flows and financing cash flows
separately. It also gives the analyst a clear picture of the strength of a firm's net cash flow after
the firm as has met all of its operating needs and paid for investments in new fixed assets and net
working capital. Referring to the data (in thousands of dollars) for Seward Manufacturing Co.,
Figure 3 shows $86,200 operating cash flow which, after netting out increases in gross fixed
assets of $14,000 and net working capital of $14, 100, leaves $58,100 in free cash flow available
to distribute to the firm's investors (and/or to spend on wasteful investments per the agency
conflict highlighted by Jensen [1986, 1989]).
By contrast, the accounting statement of cash flows breaks out the firm's cash flows into
three areas-operating acnvmes, investment activities, and financing activities-which, when
summed together, show the change in the firm's cash account (cash & equivalents). Thus, the
accounting statement of cash flows is particularly useful to the analyst interested in tracking a
firm's cash account over some time period. As shown in Figure 4, Seward recorded $61,300 cash
inflow from operating activities in 2007, which is nearly sufficient to cover the $14,000 cash
outflow from investment activities and $48,100 cash outflow from financing activities during
the year, leaving a net decrease in the firm's cash account of $800.

46 Journal of Financial

Education Fa112009
 Figure 1
Seward Manufacturing Co.
Balance Sheets as of December 31,2006-2007 ($ in
Thousands)

2006 2007
Assets
Current Assets
Cash & equivalents 21,000 20,200
Accounts receivable 42,000 33,000
Inventories 51,000 84,000
Prepaid expenses 1 ,200 ~
Total current assets 115,200 138,300
Gross fixed assets 650,000 664,000
Accumulated depreciation (364,000) (394,000)
Net Fixed assets 286,000 270,000
Total assets 401,200 408,300

Liabilities and Stockholders' Equity

Current Liabilities
Accounts payable 48,000 57,000
Notes payable 9,500 6,000
Current maturities--L.T.D. 11,500 12,000
Total current liabilities 69,000 75,000
Long-term debt 160,000 150,000
Total liabilities 229,000 225,000
Stockholders' equity
Common stock and paid-in capital 22,200 22,200
Retained earnings 150,000 161,100
Total stockholders' equity 172,200 183,300
Total liabilities & equity 401,200 408,300

Apart from the difference in focus between the cash flow identity and the accounting
statement of cash flows, these two analytical tools also differ constructionally in 1) the mix of
cash flows classified as operating activities, 2) the treatment of net working capital (current
assets minus non-interest bearing current liabilities), and 3) the recording of interest expense.
Whereas the cash flow identity limits operating cash flow

Fa1l2009 47
 Figure 2
Seward Manufacturing Co.
Income Statement for 2007 ($ in
Thousands)

2007

Sales revenue 600,000

Cost of goods sold (460,000)
Gross operating income 140,000
Operating expenses
Gen. & Adm, Expenses (30,000)
Depreciation expense (30,000)
Total operating expenses (60,000)
Net operating income (EBIT) 80,000
Interest expense (10,000)
Earnings before taxes (EBT) 70,000
Income Taxes (34%) (23,800)
Net income 46,200

Dividends paid 35,100

Addition to Retained Earnings 11,100

to earnings before interest and taxes (EBIT) adjusted for taxes and depreciation expense, the
accounting statement of cash flows incorporates into cash flow from operating activities all
revenues, expenses (including interest expense), and taxes, along with changes in individual
current assets and non-interest bearing current liabilities, Thus, interest expense is excluded
from operating cash flow within the cash flow identity and, instead, is recorded as cash flow to
debtholders. Similarly, changes in individual current assets and non-interest bearing current
liabilities are excluded from operating cash flow within the cash flow identity and, instead, are
aggregated as the change in net working capital to be subtracted, along with the change in gross
fixed assets, from operating cash flow to yield free cash flow,

48 Journal of Financial
Fal12009
Education
 Figure 3
Seward Manufacturing Co. Cash
Flow Identity for 2007 ($ in
Thousands)

2007

Operating cash flow

Earnings before interest & taxes (EBIT) 80,000
Taxes (23,800)
Depreciation expense 30,000
Operating cash flow 86,200

Change in gross fixed assets (14,000)

Change in net working capital (14,100)

(NWC = CA - noninterest bearing CL)

Free cash flow 58,100

Cash flow to debtholders & stockholders

Cash flow to debtholders
Interest expense 10,000
Net new debt issued (13,000)
Cash flow to debtholders 23,000

Cash flow to stockholders

Dividends paid 35,100
Net new equity raised
Cash flow to stockholders 35,100

Cash flow to investors 58,100

In fact, both the cash flow identity and the accounting statement of cash flows may be used
effecti vely to analyze a firm's historical performance since they contain the same information
and must necessarily reconcile with each other as well as with the balance sheet and income
statement information from which they are constructed. I I However, for potential creditors and
stockholders free cash flow within the cash flow identity more clearly presents the firm's
investment in fixed assets and net working capital in concert

Fa1l2009 49
with the firm's operating cash flow to show the cash flow remaining for distribution to the firm's
investors. In that regard, Newman [2004] reports that fixed-income investors (debtholders) are
much more interested in free cash flow information than earnings per share. J 2 And in a study of
firms that voluntarily disclosed free cash flow information over 1994-2004, Adhikari and Durn
[2006] found that while the number of firms that disclose free cash flow information is small, it
has been growing in recent years as firms with weaker GAAP financial measures seek to
augment their reported income and cash flow information. A review of the most recent financial
statements of the Dow 30 Firms, however, revealed that only five organizations reported free
cash flow information, and no two firms used the same definition of "free cash flow."
To illustrate the use of both analytical tools, compare again the data in Figures 3 and 4 for
2007. Whereas the residual cash flow for distribution to the firm's investors can be calculated
from information in the accounting statement of cash flows in Figure 4 and the income statement
in Figure 2, the cash flow identity in Figure 3 makes it immediately clear that the operating cash
flow of $86,200 in 2007 easily covered the investment of $14,000 in new fixed assets and
$14,100 in additional net working capital, leaving $58,100 free cash flow for distribution to
investors. By contrast, to get the same information from the accounting statement of cash flows,
one must 1) sum the cash flows from operating activities and investment activities ($61,300 -
$14,000 = $47,300), 2) add back interest expense ($10,000, which was subtracted as a business
expense to generate net income"), and 3) add (subtract) any decrease (increase) in the firm's
cash account (a decrease of $800 in this case, which was excluded from the calculated cash flow
from operating activities) to generate the firm's free cash flow of $58,100.
Besides the usefulness of free cash flow for historical analysis, the discounted free cash
flow method may also serve as an alternative to the dividend growth model for valuing a firm
that has no clearly defined rate of expected dividend growth. As noted earlier, a number of
textbooks mention the discounted free cash flow method for valuing a firm, even if they give
little or no attention to the concept of free cash flow in their initial discussion of a firm's cash
flow. In that regard, and consistent with our earlier algebraic derivation linking free cash flow
(within the cash flow identity) to the accounting statement of cash flows, Kousenidis [2006]
seeks to demonstrate that the free cash flow information required for firm valuation can be
derived from the operating and investing activities reported on the accounting statement of cash
flows. However, as noted earlier, Kousenidis' presentation is confusing.

SUMMARY AND CONCLUSION

Introductory financial management textbooks differ in the analytical tools they use to
introduce the concept of a firm's cash flow. Some books take a distinctly financeoriented
approach consistent with the separation of the investment and financing decisions by
emphasizing the cash flow produced by the firm's assets, commonly termed "free cash flow,"
within the cash flow identity. By contrast, other texts focus on the

50 Journal of Financial Education

Fa1l2009
 Figure 4
Seward Manufacturing Co.
Statement of Cash Flows (Indirect Method) for 2007 ($ in
Thousands)

2007

Cash & equivalents, beginning of year 21,000

Cash flow from operating activities

Net income 46,200
Plus Depreciation expense 30,000
Change in accounts receivable 9,000
Change in inventory (33,000)
Change in prepaid expenses 100
Change in accounts payable 9,000
Cash flow from operating activities 61,300

Cash flow from investment activities

Fixed asset acquisitions (14,000)
Cash flow from investment activities (14,000)

Cash flow from financing activities

Change in notes payable (3,500)
Change current maturities-- L.T.D. 500
Change in long-term debt (10,000)
Change in cornman stock & paid-in cap.
Dividends paid (35,100)
Cash flow from financing activities (48,100)

Net increase (decrease) in cash & equivalents (800)

Cash & equivalents, end of year 20,200

accounting statement of cash flows which shows the net effect of cash flows from operating
activities, investment activities, and financing activities on the firm's cash account (cash &
equivalents on the balance sheet). Still other texts highlight both the concept of free cash flow
and the accounting statement of cash flows. However, even if students are introduced to both
analytical tools, they may not readily comprehend the

Fall 2009 51
 linkage between the two tools and how they relate to each other, since textbooks generally fail
to explore the relationship between a firm's free cash flow within the cash flow identity and the
accounting statement of cash flows.
Using algebraic formulation, we derive the accounting statement of cash flows from the
cash flow identity (in which a firm's free cash flow equals its cash flow to investors), thus
illustrating that the cash flow identity and the accounting statement of cash flows are essentially
"two sides of the same coin." Using a numeric example, we also compare the information
generated by the two analytical tools, noting both the difference in focus between the tools as
well as the differences in construction.
Given the importance of understanding the concept of cash flow for purposes of both
financial statement analysis and discounted cash flow valuation, we recommend that financial
management textbooks introduce the concept of a firm's cash flow by presenting both 1) the free
cash flow concept within the context of the cash flow identity and 2) the accounting statement of
cash flows. Further, we urge textbook writers to show the relationships among free cash flow,
the cash flow identity, and the accounting statement of cash flows, as well as to compare the
information generated by the two analytical tools, noting both the difference in focus between
the tools as well as the differences in construction. Even with possible differences in the
definition of free cash flow across textbooks, making clear the linkage between free cash flow
within the cash flow identity and the accounting statement of cash flows will give students a
fuller understanding of these two analytical tools and their usefulness in financial management.

ENDNOTES

1 Ross et a1. [2008] uses the term "cash flow from assets" in lieu of "free cash flow" owing
to the fact that different analysts define "free cash flow" somewhat differently. Still, Ross et a1.
acknowledges that the two terms are essentially equivalent.
2 For a mathematical proof of the cash flow identity, see Baigent [2005].

3 Favoring this approach, Bhandari [2003] argues that, in light of the importance attached
to cash flow by the finance discipline and the usefulness of the information contained in the
accounting statement of cash flows, financial management textbooks and publishers of industry
norms should develop a common-sized statement of cash flows and begin to include more cash
flow ratios to aid analysts in evaluating a firm's financial performance.
4 Taken together, these four texts plus the four referenced earlier (or their full-length or

abbreviated counterpart) account for 80 percent of the introductory finance textbook market as
of the 2006-07 academic year, based on data compiled by Monument Information Resource
(MIR).
5 Because there is no mandated definition of "free cash flow," the result is a host of
definitions across firms and business publications, as Mills et a1. [2002] reports. Thus, different
firms may make different adjustments to present their cash flow situation in the

52 Journal of Financial

FaD 2009
Education
 most favorable light. Finance textbooks, however, are generally consistent in their definition.
6 The confusion arises as Kousenidis initially defines free cash flow as operating income
plus noncash expenses minus new investment in working capital and fixed assets, which is then
"rewritten" as operating income minus the change in the book values of current assets and fixed
assets. But the rewritten form makes no mention of noncash expenses and fails to define
explicitly the changes in the book values of current assets and fixed assets. Thus, one is left to
wonder about the equality of new investment in working capital and fixed assets and,
respectively, changes in the book values of current assets and fixed assets, as the latter terms are
intended to be defined.
7 Fraser and Ormiston [2007] present data suggesting that nearly all firms used the indirect
method in 2003. For an example of a case using the direct method and focusing on adjustments
to free cash flow for "leakages" owing to temporary and "excess" expenses, see Tipton and
Fletcher [2007].
8 LlGross fixed assets is commonly referred to as Capital expenditures or Net capital
spending and alternatively defined as L1Net fixed assets plus depreciation expense; see, e.g.,
Ross et a1 [2008]. More generally, this component would include all noncurrent assets;
however, for simplicity and like most financial management textbooks, we limit noncurrent
assets to fixed assets.
9 Again, for consistency with financial management texts we limit non-cash current assets
to accounts receivable and inventories, and non-interest bearing current liabilities to accounts
payable. More realistically, there would usually be other current assets such as prepaid
expenses and other non-interest bearing current liabilities such as accrued wages, to be factored
into LlNet working capital Additionally, we ignore any taxdeductible, non-cash expenses (other
than depreciation expense) for which there is no matching payable. Finally, we define LlCash
to include changes in cash equivalents, namely, short-term marketable securities.
10 LlDebt includes changes in any interest-bearing current liabilities such as shortterm
notes payable and current maturities oflong-term debt.
11 For excellent discussions of the use of the accounting statement of cash flows in financial
statement analysis, see Friedson and Alvarez [2002], Hertenstein and McKinnon [1997], and
Fraser and Ormiston [2007].
12 In a related study Eisdorfer [2008] reports that for firms in financial distress news about
future cash flows (defined variously but not as free cash flow) dominates expectedreturn news
in driving stock returns. This result provides an exception to that of previous research which
generally reports that stock prices move primarily in response to expected future returns rather
than expected future cash flow.
13 Because interest expense is embedded within net income, one cannot directly calculate
operating cash flow (as defined within free cash flow) from the accounting statement of cash
flows (indirect method) without knowing the firm's interest expense.

FaD 2009 53
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