Many companies and analysts take only the first of these three components, Cash Flow from operations and (rather slyly) call it simply "Cash Flow" and imply that it is a performance indicator. This definition omits the Cash Flow from financing which seems quite appropriate since borrowing or repaying loans is not in any way an indicator of profitability. But this (Operating) Cash Flow also omits the required capital spending that is necessary to replace worn out assets. For that reason it is very flawed as a measure of profitability. This definition of Cash Flow should not be used as any kind of substitute for net income.

To add to the confusion about Cash Flow another large group of companies and analysts use the term Cash Flow to mean simply net income plus depreciation and deferred income taxes. (See the "box" for an explanation of why those two items are added back to net income.) This is actually only a sub-component of Cash Flow from Operations. Technically speaking, it is Cash Flow from Operations before the "increase in non-cash working capital". This accounting jargon means the Operating Cash Flow before the net increase in money tied up in accounts receivable and inventories less the cash effectively provided by customers through accounts payable. Most growing businesses need to tie up increasing amounts of cash each year in this "working capital".

Finally, a few companies focus on "Free Cash Flow". This is best calculated as Cash Flow From Operations before changes in working capital and minus sustaining capital spending that is necessary to replace worn out assets.  Free Cash Flow can also be stated as net income plus depreciation minus sustaining capital spending. This effectively replaces the accountant's non-cash depreciation with the actual cash outlay to replace worn out assets.

Sustaining capital spending is the capital spending required to maintain current operations. It should omit capital spending on major projects and corporate acquisitions that are designed to boost growth and capacity beyond the current level of operations.

Free Cash Flow is an excellent performance measure and is often superior to net income as an indicator of value. In fact, forecast Free Cash Flow is the most theoretically sound way to place a fair value on any company (and therefore 1 share of any company). If investors focus on Free Cash Flow then they are in good company. Warren Buffett, the world's richest investor uses historic and forecast Free Cash Flow to value the businesses that he buys.

Technically, Free Cash Flow often includes the change in working capital and all capital spending. This definition of Free Cash Flow is used by business valuators and is forecast for a period of years. In this manner, all investment spending is considered and so is the cash flow that results from the total investment.

When calculating Free Cash Flow for a single year,  it is best to omit the change in working capital and discretionary, non-maintenance capital spending because the ultimate pay-off from those investments is not yet included in operating cash flow. For this reason, Free Cash Flow for a single year is calculated as Operating Cash Flow before the change in working capital less sustaining capital spending.

Free Cash Flow is the only version of Cash Flow that investors should accept as a substitute for net income.

Unfortunately most companies and analysts do not directly provide the Free Cash Flow figure. But it can often be approximated as Operating Cash Flow (before changes in working capital) less total capital investments. However, large capital spending amounts designed to materially expand the scope of operations including spending on corporate acquisitions should be omitted if it can be identified. In addition Cash Flow from Operations should ideally be adjusted to remove any material unusual or one-time items.

In many cases good old GAAP net income is a better estimate of Free Cash Flow than is so called Cash Flow due to the omissions noted above. This is particularly true in cases where depreciation is roughly equal to the capital spending that is required in an average year or quarter to replace worn out assets.

However, there are some notable situations where net income is systematically less than Free Cash Flow. In those cases a focus on Free Cash Flow could lead to identification of stocks that deserve a high P/E ratio and could lead to some bargains if the market is focusing on net income.

Certain asset intensive industries tend to have large and continuously growing amounts of deferred tax. GAAP net income treats this as an expense since it can theoretically reverse and have to be paid. In reality some companies defer these amounts indefinitely and so Free Cash Flow is systematically greater than net income for this reason.

In addition certain industries have very long lived assets that will not need to be replaced for many years. GAAP net income charges an annual depreciation expense which is often a reasonable estimate of required capital spending to replace worn out assets. But in cases where assets will not be replaced for many years, the present value of that eventual capital spending may be minimal and again annual Free Cash Flow is systematically greater than net income.

Also accounting net income always assumes the company is a going concern and that therefore capital assets will in fact be replaced as they wear out or as resources are depleted. However some companies such mines and large oil and gas deposits may be worth more as wind-down operations. In a wind-down operation Free Cash Flow tends to systematically exceed net income.

In conclusion Free Cash Flow is a superior performance and value indicator, but only if investors take the time to understand it and how to calculate it properly. The so called Cash Flow that most companies and many analysts quote is flawed as a measure of the true Free Cash Flow that a company is generating because it usually omits the necessary capital spending to replace worn out assets. Investors should ignore those flawed versions of Cash Flow. In most situations investors should simply focus on net income. However, investors should calculate and focus on Free Cash Flow in those cases as identified above where Free Cash Flow tends to systematically exceed net income.

BOX It is important to understand the major non-cash expenses that are "added back" to net income to arrive at Operating Cash Flow in all of the above definitions. Depreciation is added to net income because depreciation is a non-cash expense. It represents the share of previous spending on assets that is being charged to a particular period. Deferred income tax refers to the additional income tax that a company would have had to pay if it were subject to the full statutory income tax rate. Many asset intensive companies are allowed to claim a bigger depreciation expense for income tax purposes compared to the amount allowed under GAAP accounting rules. In theory the deferred income tax will eventually reverse and the company will have to pay it. In reality some growing companies can defer income taxes indefinitely and so simply face a lower effective cash income tax rate. The deferred income tax is therefore a non-cash expense that was not paid and is not even actually legally owed. Even if the deferred tax does reverse it will usually do so many years in the future and this creates a large "present value" saving. A deferred expense is in effect a reduced expense in terms of present value. Deferred income tax is purely an accounting construct. GAAP accounting errs on the side of being conservative by including this non-cash "expense". Deferred income tax is added back in calculating Operating Cash Flow since it is a non-cash expense.

Shawn Allen, CMA, MBA, P.Eng.

editor@investorsfriend.com July 6, 2002 (modified November 8, 2002).

www.investorsfriend.com