1. Read and summarize chapter 24 of the Financial Management book in at least 500 words.

– Answer the following questions as well:

– Explain “free cash flow.”

– How is it calculated?

– What is a statement of cash flow?

CHP24 ; Cash Flow Analysis
n  objective  of  financial  analysis  is  to  assess  a  company’s  operating
performance and financial condition. The information that an analyst
has available includes economic, market, and financial information. But
some of the most important financial data are provided by the company
in  its  annual  and  quarterly  financial  statements.  However,  the  choices
available  in  the  accrual  accounting  system  make  it  difficult  to  compare
companies’ performance. These choices also provide the opportunity for
the management of financial numbers through judicious choice of
accounting  methods.  For  example,  $1  of  net  income  for  one  company
may  not  be  equivalent  to  $1  of  net  income  of  another  company.  Cash
flows  provide  the  financial  analyst  with  a  way  of  transforming  net
income based on an accrual system to a more comparable medium. Addi-
tionally, cash flows are essential ingredients in valuation: The value of a
company  today  is  the  present  value  of  its  expected  future  cash  flows.
Therefore, understanding past and current cash flows may help the analyst  in  forecasting  future  cash  flows  and,  hence,  determine  the  value  of
the  company.  Moreover,  understanding  cash  flow  allows  an  analyst  to
assess the ability of a firm to maintain current dividends and its current
capital expenditure policy without relying on external financing.
DIFFICULTIES WITH MEASURING CASH FLOW
The  primary  difficulty  with  measuring  a  cash  flow  is  that  it  is  a  flow:
Cash  flows  into  the  company  (cash  inflows)  and  cash  flows  out  of  the
company  (cash  outflows).  At  any  point  in  time  there  is  a  stock  of  cash
on hand, but the stock of cash on hand varies among companies because
of the size of the company, the cash demands of the business, and a com-
A
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798 FINANCIAL STATEMENT ANALYSIS
pany’s  management  of  working  capital.  So  what  is  cash  flow?  Is  it  the
total amount of cash flowing into the company during a period? Is it the total
amount of cash flowing out of the company during a period? Is it the net
of the cash inflows and outflows for a period? Well, there is no specific
definition of cash flow—and that’s probably why there is so much con-
fusion  regarding  the  measurement  of  cash  flow.  Ideally,  the  analyst
needs a measure of the company’s operating performance that is compa-
rable among companies—something other than net income.
A simple, yet crude method of calculating cash flow requires simply
adding  noncash  expenses  (e.g.,  depreciation  and  amortization)  to  the
reported  net  income  amount  to  arrive  at  cash  flow.  For  example,  the
estimated cash flow for Procter & Gamble (P&G) for 2002, is:
This amount is not really a cash flow, but simply earnings before depre-
ciation and amortization. Is this a cash flow that analysts should use in
valuing  a  company?  Though  not  a  cash  flow,  this  estimated  cash  flow
does allow a quick comparison of income across firms that may use dif-
ferent depreciation methods and depreciable lives.1
The  problem  with  this  measure  is  that  it  ignores  the  many  other
sources  and  uses  of  cash  during  the  period.  Consider  the  sale  of  goods
for credit. This transaction generates sales for the period. Sales and the
accompanying cost of goods sold are reflected in the period’s net income
and the estimated cash flow amount. However, until the account receiv-
able is collected, there is no cash from this transaction. If collection does
not  occur  until  the  next  period,  there  is  a  misalignment  of  the  income
and  cash  flow  arising  from  this  transaction.  Therefore,  the  simple  esti-
mated cash flow ignores some cash flows that, for many companies, are
significant.
Another estimate of cash flow that is simple to calculate is EBITDA—
earnings before interest, taxes, depreciation, and amortization. However,
this measure suffers from the same accrual-accounting bias as the previ-
ous measure, which may result in the omission of significant cash flows.
Estimated cash flow = Net income + depreciation and amortization
Estimated cash flow = $4,352 million + 1,693 million
= $6,045 million
1 An example of the use of this estimate of cash flow, The Value Line Investment Sur-
vey, published by Value Line, Inc., reports a cash flow per share amount, calculated
as  reported  earnings  plus  depreciation,  minus  any  preferred  dividends,  stated  per
share  of  common  stock  [Guide  to  Using  the  Value  Line  Investment  Survey,  New
York: Value Line, Inc., p. 19, available at http://www.valueline.com].
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