Cash flow statements began appearing in corporate reports almost 30 years ago, after FASB issued Statement of Financial Accounting Standards (SFAS) 95, Statement of Cash Flows, in 1987. Previously, business enterprises published a funds statement per APB Opinion 19, Reporting Changes in Financial Position, issued in 1971. The cash flow statement was a major improvement, as working capital flows are highly correlated with earnings and do not provide much information beyond the net income number. Cash flows, on the other hand, supply much-needed information about the liquidity and solvency of a corporation and act as an important adjunct for assessing earnings quality (Howard Schilit, Financial Shenanigans, 2nd ed. McGraw-Hill, 2002).

Perhaps the most important number on the cash flow statement is the cash flow from operating activities, also called operating cash flows or cash from operations. An important variation of cash flow from operating activities is free cash flow, which is defined as cash flow from operating activities less capital expenditures. Creditors find this metric valuable when trying to evaluate a firm’s liquidity and solvency. Equity investors and short sellers also find free cash flows important when attempting to determine an entity’s valuation.

Free cash flow is more comparable to net income than operating cash flows because net income includes a subtraction for depreciation charges. Cash flow from operating activities omits depreciation and similar charges, as these designate cost allocations rather than cash flows. This, however, ignores the fact that depreciation charges and the concomitant gain or loss on disposition do in fact equal the firm’s cash flows with respect to the asset being depreciated. Because free cash flow includes cash flows for capital assets—which are analogous to depreciation, as explained below—free cash flow is the better metric to employ when comparing and contrasting the entity’s earnings and cash flows. This also applies to assets that are depleted, amortized, or subject to impairment charges.

What happens when a company acquires land, buildings, or other capital assets via a business combination? The cash flow statement presents all of the cash flows pertaining to the merger or acquisition in the cash flow from investing activities as one item. For example, Merck displays its investment in Idenix on its 2014 cash flow statement as “Acquisition of Idenix Pharmaceuticals, Inc., net of cash acquired.” Many users unwittingly ignore what is packed into that line item when computing free cash flow. To obtain a more informative measure when calculating capital expenditures, users should include what is spent to acquire land, building, and other capital assets—even if obtained via a business combination. For example, a user can read in Merck’s Note 4 that it spent $3.2 billion to purchase R&D. Merck’s capital expenditures in 2014 include this $3.2 disbursement, as well as payments made through its normal vendor channels.

Free cash flow is overestimated when one ignores capital expenditures made in a business acquisition and embraces only capital expenditures made in ordinary transactions. The form of the transaction is irrelevant to the analysis; expending resources to obtain a capital asset is always a capital expenditure. By including such capital expenditures in the analysis, the user obtains better measures of free cash flow.

Importance of Free Cash Flow

Free cash flow has long proved a useful measure in the analysis and interpretation of corporate performance. While there are several variations, free cash flow is typically calculated as cash from operating activities minus capital expenditures. Cash from operating activities, of course, is the bottom line of the operating activities section of the cash flow statement, while cash outflow for capital expenditures is usually a line item within the investing activities section. Standards setters do not require businesses to publish free cash flow; indeed, the SEC refers to it as one of the non-GAAP numbers that registrants might report and has issued Regulation G to govern how it is displayed. Nonetheless, many users find the free cash flow number important in their decision-making processes.

When assessing a business entity’s liquidity and solvency, lenders will employ several financial numbers and ratios, including free cash flow. The major credit rating agencies all utilize free cash flow in their credit analysis, though there are differences in the calculation. Standard & Poor’s refers to the measure as free operating cash flow and equates it to cash flow from operations minus capital expenditures (Standard and Poor’s Encyclopedia of Analytical Adjustments for Corporate Entities, Jul. 9, 2007, Moody’s computes free cash flow as cash flow from operations minus capital expenditures, minus common dividends, minus preferred dividends, minus minority dividends (Moody’s Basic Definitions for Credit Statistics, Fitch computes it as cash flow from operations minus nonoperating and nonrecurring cash flow, minus capital expenditures, minus dividends paid (Dufry AG Ratings Report, Sept. 3, 2015,

Equity investors and analysts employ free cash flow as an input to their valuation models. A simple constant growth valuation model is to equate value with current free cash flow divided by an appropriate discount rate minus the constant growth rate. Another popular model is to assess value as the present value of future free cash flows to the business, discounting the free cash flows with the weighted average cost of capital Alternatively, one can estimate the equity value as the present value of future free cash flows to common shareholders, discounting the free cash flows with the cost of equity, where the cost of equity is the rate of return required by stockholders to bear the risk of investing. An excellent resource for researching these and other models is Analysis of Equity Investments: Valuation by John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2002).

Forensic accountants and others interested in the quality of earnings find free cash flow quite helpful. If earnings are much higher than free cash flow over a period of time, one might wonder whether income is aggressively computed. If the methods differ greatly, it may indicate intentional or unintentional misstatements in the determination of income.

Auditors can also examine their clients’ free cash flows. The company’s free cash flows could be a piece of evidence when making a preliminary judgment about client risk and in carrying out some of the initial audit planning. Cash flow ratios and a comparison of earnings to free cash flow would be helpful components when performing preliminary analytical procedures. Free cash flows are also informative when assessing the going concern of the audit client.

Relationship of Depreciation to the Asset’s Net Cash Flows

Revenues and the expenses found on the income statement have their counterparts in the cash flow statement. This is most easily seen in the direct format, although it is also true for the indirect format. Cash flow from customers equals revenues minus the change in accounts receivable. Cash paid to vendors equals cost of goods sold plus the change in inventory, minus the change in accounts payable. Cash paid for other operating items equals the expense plus the change in the associated current asset or minus the change in the associated current liability. To this extent, the cash flows from operating activities complements the income statement, but they do not completely correspond to each other; one statement includes depreciation, depletion, and amortization, while the other excludes them.

Cash flow from operating activities omits depreciation and similar charges because they designate cost allocations that take the cost of the asset and spread it over the asset’s life in a rational and systematic order. In this sense, depreciation is not a cash flow. Even so, depreciation has its counterpart to cash flow. For any long-term asset, the sum of the depreciation charges and the gain or loss on disposition equals the cash paid for the asset minus the cash received upon its exit. In this sense, depreciation, along with the gain or loss recognized upon disposal, reflects the enterprise’s cash flows for that asset.

Exhibit 1 illustrates this relationship. Assume a company pays $5,000 for an asset and sells it four years later for $1,000. The net cash outflow is $4,000. There are four possible accounting methods, all of which employ straight-line depreciation with various lives (four or five years) and with various salvage values ($0 or $1,000). In all cases, the depreciation charges plus the gain or loss on disposal equal $4,000. Thus, for any long-term asset, the sum of the depreciation charges and the gain or loss on disposition equals the cash paid for the asset minus the cash received upon its disposal. This relationship is true for any depreciation method, any life, and any salvage value. This is because the gain or loss acts as a settling-up mechanism. If the depreciation correctly allocates the net cash flow, then there is no gain or loss. If the depreciation overestimates the net cash flow, then there is a gain; if it underestimates the net cash flow, there is a loss. In each case, the gain or loss is the amount of the over- or underestimate.


Link between Depreciation and Cash Flow

Case; Depreciation Method; Life; Salvage Value; Depreciation Expense; Accumulated Depreciation; Gain (Loss) on Disposal; Depreciation Gain (Loss) Year 1; Year 2; Year 3; Year 4 1; Straight-line; 4; %image_alt%; ,250; ,250; ,250; ,250; ,000; ,000; ,000 2; Straight-line; 4; 1,000; 1,000; 1,000; 1,000; 1,000; 4,000; 0; 4,000 3; Straight-line; 5; 0; 1,000; 1,000; 1,000; 1,000; 4,000; 0; 4,000 4; Straight-line; 5; 1,000; 800; 800; 800; 800; 3,200; (800); 4,000

This logic extends to assets that are subject to depletion or amortization charges, because depletion and amortization are the same cost allocation process. The logic also extends to intangible assets that do not have a definite life; instead of depreciation charges, these assets would show impairment losses. When the asset is disposed, the company records a gain or loss, and this too would act as a settling-up process. Cash paid for the asset less cash received when sold is equal to the sum of the impairment charges and the gain or loss upon disposal.

Analyzing Assets Obtained in a Business Combination

When users compute free cash flow, they generally subtract the cash flow for purchases of property, plant, and equipment—a line often found in the investing activities section of the cash flow statement—from the cash flow from operating activities. There may, however, be additional property, plant, and equipment that is purchased via a merger or acquisition. The entity will depreciate this property, plant, and equipment and recognize the gain or loss when the asset is disposed of. As stated above, ignoring assets obtained through a business purchase overstates the corporate free cash flow, and users should adjust the usual formula for free cash flow to avoid this bias in the metric. This advice also applies to intangibles such as in-process R&D.

To illustrate the importance of this dictum, the author examined four companies in the pharmaceutical industry: Johnson & Johnson, Merck, Pfizer, and Valeant. Exhibit 2 shows their net income, cash flow from operations, capital expenditures, and free cash flow for the years 2010–2014, as well as the merger and acquisition (M&A) capital expenditures, which are found in a note describing the business purchases. These M&A capital expenditures are then subtracted from free cash flow to provide an adjusted free cash flow.


Free Cash Flows for Pharmaceutical Companies (dollars in millions)

2010; 2011; 2012; 2013; 2014 Johnson & Johnson Net Income; ,334; ,672; ,853; ,831; ,323 Cash Flow from Operations; 16,385; 14,298; 15,396; 17,414; 18,471 Capital Expenditures; 2,384; 2,893; 2,934; 3,595; 3,714 Free Cash Flows; 14,001; 11,405; 12,462; 13,819; 14,757 M&A Capital Expenditures; 1,398; 3,639; 15,993; 1,772; 3,982 Adjusted Free Cash Flows; 12,603; 7,766; -3,531; 12,047; 10,775 Merck Net Income; 2; ,392; ,299; ,517; ,934 Cash Flow from Operations; 10,822; 12,383; 10,022; 11,654; 7,860 Capital Expenditures; 1,700; 1,700; 2,000; 1,500; 1,300 Free Cash Flows; 9,122; 10,683; 8,022; 10,154; 6,560 M&A Capital Expenditures; 328; 420; 0; 189; 3,343 Adjusted Free Cash Flows; 8,794; 10,263; 8,022; 9,965; 3,217 Pfizer Net Income; ,288; ,051; ,598; ,072; ,168 Cash Flow from Operations; 11,454; 20,240; 16,746; 17,684; 16,883 Capital Expenditures; 273; 3,282; 1,050; 15; 195 Free Cash Flows; 11,181; 16,958; 15,696; 17,669; 16,688 M&A Capital Expenditures; 500; 362; 1,219; 0; 459 Adjusted Free Cash Flows; 10,681; 16,596; 14,477; 17,669; 16,229 Valeant Net Income; -8; 6; -6; -6; 4 Cash Flow from Operations; 263; 640; 657; 1,042; 2,295 Capital Expenditures; 17; 386; 181; 185; 278 Free Cash Flows; 246; 254; 476; 857; 2,017 M&A Capital Expenditures; 5,205; 1,767; 2,649; 6,286; 841 Adjusted Free Cash Flows; -4,959; -1,513; -2,173; -5,429; 1,176 M&A=Mergers and Acquisitions

For all four companies, the free cash flow is lower than the cash flow from activities, and the adjusted free cash flow is equal to or lower than the unadjusted free cash flow. These results follow naturally from the terms’ definitions; of more interest is the amount of the difference. Several of the M&A capital expenditures are small, less than 10% of the unadjusted free cash flow; however, some differences are much larger, as seen in 2012 for Johnson & Johnson and in 2010–2013 for Valeant. These changes are so large that the adjusted free cash flow number becomes negative.

Another way to view these data is to contrast the cash flow measures against earnings. Exhibit 3 displays three ratios for these companies across 2010-2014: cash flow from operations/net income, free cash flow/net income, and adjusted free cash flow/net income. These ratios only have meaning when net income is positive, so any ratio with a negative net income is marked not applicable.


Cash Flow Ratios for Pharmaceutical Companies

2010; 2011; 2012; 2013; 2014 Johnson & Johnson CFO/NI; 1.23; 1.48; 1.42; 1.26; 1.13 FCF/NI; 1.05; 1.18; 1.15; 1.00; 0.90 Adj. FCF/NI; 0.95; 0.80; -0.33; 0.87; 0.66 Merck CFO/NI; 11.02; 1.94; 1.59; 2.58; 0.66 FCF/NI; 9.29; 1.67; 1.27; 2.25; 0.55 Adj. FCF/NI; 8.96; 1.61; 1.27; 2.29; 0.27 Pfizer CFO/NI; 1.38; 2.01; 1.15; 0.80; 1.84 FCF/NI; 1.35; 1.69; 1.08; 0.80; 1.82 Adj. FCF/NI; 1.29; 1.65; 0.99; 0.80; 1.77 Valeant CFO/NI; N/A; 4.10; N/A; N/A; 2.51 FCF/NI; N/A; 1.63; N/A; N/A; 2.21 Adj. FCF/NI; N/A; -9.70; N/A; N/A; 1.29 CFO/NI=Cash Flow/Net Income FCF/NI=Free Cash Flow/Net Income Adj. FCF=Adjusted Free Cash Flow

Ignoring assets obtained through a business purchase overstates the corporate free cash flow.

Cash flow from operating activities is generally greater than net income; only Pfizer in 2013 has a ratio of less than one. Free cash flow/net income is usually greater than one, indicating high quality earnings. The outcome changes, however, in some instances when one includes the capital assets obtained in a business purchase. Adjusted free cash flow/net income is greater than one in four years for Merck and for three years for Pfizer, but less than one for Johnson & Johnson for all years. Valeant has only one good showing for this variable, in 2014.

For the purposes of assessing quality of earnings, the inclusion of capital expenditures for assets obtained in a merger or acquisition does not change for three of the companies. For Johnson & Johnson, however, free cash flow/net income is generally greater than one, while adjusted free cash flow/net income is less than one in all five years. Interpreting the quality of earnings with this ratio depends on whether one incorporates all of the capital expenditures.

Of course, these observations do not constitute a full and adequate financial statement analysis. Rather, they provide insight into the importance of including in capital expenditures those cash flows for assets obtained in a business combination.

The Better Metric

Free cash flow is a superior measure to operating cash flow because it adjusts for capital expenditures made by the business entity. Accordingly, the ratio of free cash flow to net income is better than the ratio of cash flow from operations to net income. Creditors and equity investors should determine free cash flow when they are assessing corporate liquidity and when they are evaluating the quality of earnings.

It is also important to include all capital expenditures when computing free cash flow. One important source that is usually omitted is the capital expenditures arising out of a business combination. By reading the notes carefully, a user can find these capital expenditures and incorporate them in the analysis.

J. Edward Ketz, PhD is an associate professor in the Smeal College of Business at Pennsylvania State University, University Park, Pa.