CHAPTER TEN
Understanding Free Cash Flow
Free cash flow is the lifeblood of a company.1
Unless a company can generate cash to fund growth and pay dividends, its shares are essentially worthless.2
If you want a fair measure of extractable cash, the ultimate end in running a business, try free cash flow.3
References to free cash flow and its importance to financial analysis and firm valuation can be found with great frequency in investment literature and the financial press. Consider the quotes provided above. In different ways, each one attests to the absolute importance of free cash flow to a firm’s valuation. For an investor or creditor to disagree with such statements would be like arguing with a sun worshiper about the desirability of blue skies over the beaches of Florida or taking exception to the wishes of skiers for more snow. Ultimately, the interest of investors and creditors in free cash flow is why for-profit firms are formed. The objective of such business enterprises is to generate cash flow for the purpose of servicing claims and providing returns to owners.
Business managers are gaining an appreciation for the importance to investors and creditors of generating free cash flow. Consider Borders Group, Inc., for example. The next statement was made in a comment about corporate strategy in the management’s discussion and analysis section of the company’s annual report for the year ended January 25, 2004: “The Company is continuing to implement its plan for the optimization of the Waldenbooks’ store base in order to improve sales, net income and free cash flow.”
4Consider also this comment from a spokesperson at
Amazon.com, Inc., where the importance to management of free cash flow is stressed: “We think all the GAAP (generally accepted accounting principles) numbers are important, but the one management is most focused on is free cash flow.”
5 That statement is consistent with the company’s stated objective, which, according to its annual report is “long-term, sustainable growth in free cash flow.”
6Managers at other firms have embraced the concept of free cash flow to the point of incorporating it into formulas used for calculating incentive compensation. For example, the next statement reflects a change in the compensation agreements at Delta Air Lines, Inc., to incorporate free cash flow: “Last year, company documents show, the board of directors changed the rules to award bonuses based on so-called ‘free cash flow.’”
7The importance of free cash flow to analysis and valuation is not of recent vintage. Cash flow in general and free cash flow in particular always have been of ultimate importance to investors and creditors, or, at least, such cash flow measures are what should have been of importance to them. Yet recently there has been a growing “discovery” of sorts of the measure by investors, creditors, and the financial press. Consider, for example,
Exhibit 10.1, where we graph references to free cash flow noted in the financial press for the period 1996 through early 2004.
In the exhibit, we graph the number of references to the term “free cash flow” appearing in The Wall Street Journal, Barron’s, and Dow Jones Newswires for each year starting in 1996 and running through the quarter ended March 31, 2004. Although these citations included in-depth stories about free cash flow and how it was measured, most of them were short references to improvements or declines in free cash flow noted in company press releases or analyst reports. These announcements were then picked up by Dow Jones Newswires and included in our survey count.
As seen in the exhibit, a growing interest in free cash flow is unmistakable. In the financial press outlets we reviewed, only 15 references were made to free cash flow during 1996. There was a jump to 55 references in 1997 and a gradual upward trend to 108 references in 2000. After 2000, the number of references to free cash flow in the financial press increased dramatically each year to 322 in 2003. The increase continued during 2004, rising to 136 references during the first quarter ended March 31, 2004, which annualizes to a total of 544 references for the full year.
Exhibit 10.1 References to Free Cash Flow in the Financial Press, January 1, 1996-March 31, 2004 (2004 amount annualized)
Source: The Wall Street Journal.com. Search was made for all references to “free cash flow” in
The Wall Street Journal, Barron’s, and
Dow Jones Newswires for each year, 1996 to 2003, and for the quarter ended March 31, 2004. References for the quarter ended March 31, 2004, were annualized.
Earlier we noted that both Border’s Group and
Amazon.com incorporated free cash flow into their stated corporate strategies. We were interested in determining whether this was a recent development. For that purpose, we looked at earlier annual reports for Border’s and noted that a reference to free cash flow first appeared in the company’s report for the year ended January 27, 2002. In annual reports prior to that, the company’s stated business strategy was focused on growth and profits, but not free cash flow. This statement describes the company’s strategy in the year ended January 28, 2001: “The Company’s business strategy is to continue its growth and increase its profitability.”
8 Consistent with Border’s,
Amazon.com did not mention free cash flow as part of its business objective in years prior to December 31, 2001.
What is remarkable about the growing interest in free cash flow is that, as noted, its importance to analysis and valuation is not new. The value of a share always has been the present value of the expected cash flows to which that share entitles its owner. Also, cash flow always has been what pays principal and interest on loans. So why are we now seeing such increased interest in free cash flow? We think that it is a natural reaction to the numerous and well-publicized accounting problems and examples of egregious acts of earnings management witnessed in recent years.
The accounting debacle we know as Enron Corp. occurred in 2001, the same year that interest in free cash flow began to increase dramatically. Certainly Enron was not the first accounting fraud of recent times. We had already seen serious accounting-rule violations and material restatements at such firms as Cendant Corp., Sunbeam Corp. and Xerox Corp. Enron, however, was a larger, more pervasive fraud in which a significant number of average people lost large amounts of money. Many of them lost their retirement plans and life savings. The story captured the attention of many as terms such as “accounting fraud” and “earnings management” became part of our national lexicon.
After Enron, there was an extended period during which new accounting frauds seemed to be announced almost every day. Names like Dynegy, Inc., Adelphia Communications Corp., and certainly WorldCom, Inc., were constantly in the news. We almost began to expect “perp walks” as alleged perpetrators of accounting frauds were taken into custody.
To differing degrees, each of the cases mentioned here along with many others entailed the reporting of fictitious earnings and restatements of prior-year amounts. Enforcement actions taken by the Securities and Exchange Commission against these firms and others often demonstrated the lengths to which managers would go in their quest to report fake profits.
Understandably, investors, creditors, and analysts began to question earnings more than ever. They longed for something better, a metric on which they could place more reliance and trust for purposes of analysis and valuation. Free cash flow was a natural candidate. It was viewed as an antidote of sorts to creative accounting and earnings management. It was somehow more pure, above the fray and immune to the problems besetting reported earnings.
Several quotes, provided in Chapter 1, capture this view well. We repeat two of them here:
Cash is fact and accounting profit is opinion.9
Unlike some items that can be clouded with financial reporting issues, cash is real, finite, and measurable. Cash is cash. 10
The common theme in both of these quotes is that although earnings can be manipulated, cash cannot. And although the quotes themselves do not use the term “free cash flow,” they do demonstrate why interest in various measures of cash flow, including free cash flow, has grown so quickly of late.
We welcome the growing attention placed on free cash flow. We think that it provides evidence that investors and creditors are emphasizing what really matters to analysis and valuation. However, we are not advocating a single focus. We have made the point throughout this book and others that one cannot focus on cash flow and ignore earnings, or vice versa. A company services its debt and creates value for its shareholders through the generation of sustainable cash flow. To be sustainable, cash flow requires earnings support. Thus, a company’s ability to generate both earnings and cash flow is important to all claimants.
We are concerned that there is not much understanding of what constitutes free cash flow. Definitions of the measure vary as does its calculation. Moreover, contrary to the quote made by a spokesperson at
Amazon.com, where it was noted that free cash flow is a GAAP measure, GAAP does not define free cash flow.
Because there is a general lack of understanding as to what constitutes free cash flow, there is a real risk that managers, knowing that investors and creditors are focused on it, will turn their attention to using creative means toward giving them what they want. If financial statement users are not properly armed to see through this obfuscation, they may become disillusioned and lose interest in what is a very intuitively appealing measure. If so, attention paid to free cash flow will fade, and we may look back at this period of heightened attention to it as little more than a passing fad.
Our hope is that free cash flow only grows in importance. We think that by helping investors and creditors better understand how it is measured and how it might be manipulated, which is the objective of this chapter, use of free cash flow in analysis and valuation will continue and grow.
USES OF FREE CASH FLOW
Free cash flow is normally thought of first in the context of firm valuation. Consider this quote, which refers to the stock-picking approach of a successful money manager,
The . . . manager of JPMorgan Mid Cap Value Fund favors strong free cash flow—which he defines as cash from operations minus captal spending—when selecting undervalued companies that he thinks will do well in the long run.
11The comment about how free cash flow might be used is rather vague. However, its importance to valuation is clear. The likelihood is that the manager, like others who use free cash flow in valuation, incorporates it into some discounted cash flow model for the purpose of determining an intrinsic value for a share.
Although free cash flow normally is thought of first as a valuation metric, it has other important uses. For example, creditors might use it in financial covenants that are designed to restrict corporate behavior and increase the likelihood of repayment. Other firms, understanding the importance of free cash flow to valuation, may use it in developing an incentive compensation plan. Finally, because accounting standards call for the use of undiscounted cash flows in determining whether assets are value impaired, some firms have found that free cash flow is an appropriate measure to use for that purpose.
A broad understanding of free cash flow begins with an appreciation for how the measure is used. In this section we look closely and provide examples of how free cash flow is employed for the purposes mentioned—in share valuation, in management incentive compensation plans, in restrictive debt covenants, and for purposes of asset impairment testing.
Valuation
A traditional model for valuing any asset is to find the present value of the expected future cash flows to be generated by the asset. The model can be expressed by the next equation:
where
t = time period
n = life of the asset
CFt = cash flow in period t
r = discount rate reflecting the riskiness of the estimated cash flow
Although the valuation model looks relatively simple, it is dependent on several key assumptions. For example, the model incorporates assumptions about the specific cash flow that is being discounted, the number of time periods over which that cash flow will be generated, and an assumed discount rate. Because our interest is in better understanding free cash flow, our attention here will address the first key assumption in the valuation model—the specific cash flow that is being discounted.
For valuation purposes, the cash flow of interest depends on the specific asset being valued. For example, if the asset were a bond, then the relevant cash flow would be the scheduled interest and principal payment stream. If the asset were a preferred share of stock, then preferred dividends, either into perpetuity or with an assumed liquidation value, would be used.
If the model were valuing the firm as a whole, the cash flow of interest would be cash flow available for all claimants, debt holders, preferred shareholders, and common shareholders, after operating expenses and taxes had been paid. For common shareholders, the cash flow of interest would be cash available after prior claims had been serviced, including taxes, interest, and preferred dividends.
Even though the asset valuation model described here does not explicitly use the term “free cash flow,” it certainly could. Typically, free cash flow is thought of from the viewpoint of either the firm or the common shareholders. Thus, instead of referring to the present value of expected cash flow for purposes of valuing the firm or common equity, the valuation model could have referred to the present value of free cash flow available for each group.
In a subsequent section, we will turn our attention to the definition and calculation of free cash flow. We will look at free cash flow to the firm, that is, for all claimant groups including debt holders, preferred shareholders, and common shareholders, and free cash flow available for common shareholders only. What will become apparent is that the definition of free cash flow will depend on the claimant group for whom the measure is being defined.
Incentive Compensation
Given the importance of free cash flow to valuation, it is no surprise that the measure has found its way into incentive compensation plans. By linking incentive pay to free cash flow, compensation agreements are better able to tie an individual manager’s success to an important component of firm-wide success. Moreover, like sales growth, earnings growth, or return on equity, which are more traditional indicators of corporate achievement, a manager can be viewed as having more direct control over free cash flow than a firm’s share price, for example.
Because shareholders are, for obvious reasons, very concerned about increases in a company’s share price, price often is used as the basis for incentive compensation. For example, it is of paramount importance in stock option plans. If share price does not increase after the option grant date, most options will expire worthless. The premise of such plans is to tie the financial rewards of a company’s management in with the financial well-being of its owners. The problem with these plans is that share price may move in a direction that is seemingly unrelated to a company’s financial performance. Share price may linger or even decline for years even as managers are successful in boosting sales, earnings, and cash flow. As a result, stock-related plans may not provide the kind of incentive that compensation committees seek.
Although traditional financial measures, such as sales growth, earnings growth, and return on equity, do reflect directly the efforts of management, the link between such measures and improvements in share price is not as compelling as the association between free cash flow and share price. According to most valuation models, increases in free cash flow will translate directly into increases in share price. While an actual share-price response may be delayed due to other extraneous factors outside of management’s control—for example, a rise in interest rates or a threat of increased terrorist activity—over time, a company’s share price will respond.
Thus, free cash flow offers an incentive measure that can be linked directly to share price and reflects the efforts of management. It is thus a very compelling gauge on which to base incentive compensation.
We surveyed corporate filings and found many examples of the use of cash flow in compensation agreements. The computations in some of the agreements referred to the use of cash flow in describing incentive compensation but provided no additional explanation. Others were a bit more descriptive and employed operating cash flow or cash provided by operating activities. In addition to these firms, we noted several firms that referred to the use of free cash flow in their incentive compensation calculations.
The results of our survey are presented in three exhibits.
Exhibit 10.2 presents companies and references to incentive compensation agreements that used cash flow in their calculations without additional explanation. The companies in
Exhibit 10.3 make reference to the use of
operating cash flow in computing incentive compensation.
Exhibit 10.4 presents those firms that made use of
free cash flow in their incentive agreements.
In
Exhibit 10.2, we list three firms that made reference to the use of cash flow in their compensation agreements but that provided no clarification of what specific cash flow amount was being measured. One can only wonder how the so-called cash flow measure was calculated and whether the intent was to focus on another measure, such as operating cash flow or free cash flow. Two of the three firms made reference to other, more traditional measures of financial performance in their compensation agreements. For example, Newell Rubbermaid, Inc., noted that bonuses were based on growth in sales, operating income, cash flow, and earnings per share. Washington Post Co. also made reference to revenue, operating income, and cash flow. Weyerhauser Co. mentioned only that it used “challenging performance benchmarks,” for which it provided 10 percent annual increase in cash flow as an example.
The firms listed in
Exhibit 10.3 made use of the more descriptive operating cash flow in their compensation agreements. For example, Nextel Communications, Inc., based its performance goals on increases in operating cash flow and subscribers over a two-year period.
General Electric Co. is included in this list. The company’s description of how it uses operating cash flow in computing incentive compensation is rather pointed. According to the company, certain performance share units will convert into shares of stock in GE if GE’s cash flow from operating activities “increases an average of ten percent or more per year during the five-year period from 2003 through 2007.”
12Exhibit 10.2 Cash Flow Used in Calculating Incentive Compensation
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Reference to Cash Flow in Compensation Agreement |
|---|
| Newell Rubbermaid, Inc. (Form DEF 14A, March 26, 2004) | The Company’s group presidents and other management level employees, including the Named Officers, are eligible to participate in the Company’s Bonus Plan. In 2003, payments to participants were based on a combination of sales growth, operating income, cash flow and earnings per share. |
| Washington Post Co. (Form DEF 14A, March 23, 2003) | In the case of executive officers with responsibility for a particular business unit, such unit’s financial results are also considered, including, depending on the business unit, revenue, operating income and cash flow. |
| Weyerhauser Co. (Form DEF 14A, March 10, 2004) | The restricted share program should utilize justifiable operational-performance criteria combined with challenging performance benchmarks for each criterion (e.g., 10% annual increase in cash flow). |
Exhibit 10.3 Operating Cash Flow Used in Calculating Incentive Compensation
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Reference to Cash Flow in Compensation Agreement |
|---|
| Comcast Corp. (Form 10-K, December 31, 2003) | “Quantitative Performance Standards” means performance standards such as income, expense, operating cash flow, numbers of customers or subscribers for various services and products offered by the Company or a division, customer service measurements and other objective financial or service-based standards relevant to the Company’s business as may be established by the Committee. |
| General Electric Co. (Form DEF 14A, March 2, 2004) | 125,000 of the performance share units will convert into shares of GE stock only if GE’s cash flow from operating activities has grown an average of 10% or more per year during the five-year period from 2003 through 2007. |
| Nextel Communications, Inc. (Form DEF 14A, April 25, 2003) | The compensation committee has adopted a longterm incentive plan intended to reward key members of Nextel’s management for achieving specific performance goals relating to operating cash flow and net subscriber additions over a two-year period commencing January 1, 2002. |
In
Exhibit 10.4, we see a list of firms that made reference to free cash flow in their compensation agreements. Most of the firms listed included free cash flow along with other, more traditional measures of financial performance. Often the use of these measures was defended because of their perceived link to shareholder returns. For example, Bausch & Lomb, Inc., noted that free cash flow, as well as sales and earnings among other measures, were used because they represent key shareholder return indicators. Motorola, Inc., indicated that it focused on operating earnings and free cash flow because the two measures were considered critical to improving shareholder returns. What is interesting about the company’s statement is that it did not use free cash flow in its compensation agreements prior to 2002. The company’s change is consistent with the observation made earlier that the embrace of free cash flow is a recent phenomenon.
Creative Cash Flow Reporting and Incentive Compensation
In
Exhibits 10.2,
10.3, and
10.4, we saw many examples of companies that employed various measures of cash flow, including free cash flow, for the purpose of computing incentive compensation. Although cash flow appears to provide a sensible measure on which to base incentives, we wonder whether adjustments are being made to cash flow before incentives are computed.
Exhibit 10.4 Free Cash Flow Used in Calculating Incentive Compensation
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Reference to Cash Flow in Compensation Agreement |
|---|
| American Standard Cos., Inc. (Form 8-K, January 26, 2004) | Each year we establish an operating plan that sets goals for overall corporate and operating unit performance with specific financial and strategic measures. In 2003, these included sales growth, earnings per share, free cash flow, as well as individual goals. |
| Bausch & Lomb, Inc. (Form DEF 14A, March 25, 2004) | Operating unit performance is measured against targets established for sales, earnings, free cash flow, cost improvement initiatives, and strategic projects, tying incentive compensation to key shareholder return indicators. |
| Kraft Foods, Inc. Form DEF 14A, March 5, 2004) | In determining . . . compensation, the Committee considered individual performance with respect to the achievement of key strategic, financial, and leadership development objectives, including income growth, volume growth, productivity savings, new product development, increasing market share and increasing free cash flow. |
| Motorola, Inc. (Form DEF 14A, March 12, 2004) | The Motorola Incentive Plan (MIP) . . . focuses on operating earnings (OE) and free cash flow, two measures critical to improving shareholder returns. OE and free cash flow targets are established for the Company and each of its major sectors. While most employees are rewarded based on sector performance, high-level elected officers (including the executives named in the Summary Compensation Table) have a significant portion of their award based on the OE and cash flow of the entire Company. |
| Tyco International, Ltd. (Form DEF 14A Jan. 28, 2004) | Annual incentive bonus opportunities for segment presidents . . . were based upon the Compensation Committee’s and senior management’s assessment of the respective segment’s financial performance, evaluated using earnings before interest and taxes (“EBIT”) and Segment Free Cash Flow, with a portion of the annual incentive bonus based on the overall performance of Tyco, using Earnings Per Share (“EPS”) and total Company Free Cash Flow as the measures. |
For example, would managers earn a bonus if operating cash flow and correspondingly free cash flow were increased because management delayed the payment of vendor payables? What if free cash flow were increased because receivables were sold through a securitization agreement? A reclassification of investments to a trading designation also would boost free cash flow when the investments were sold. Would cash flow provided in this manner result in an increase in incentive compensation?
We do not think that nonrecurring cash flow provided through creative means, whether within or beyond the boundaries of GAAP, should provide the basis for increased compensation. However, as we have seen, cash flow is very open to so-called creative reporting. Accordingly, there is a risk that managers may employ such practices to increase free cash flow when corporate performance has not really improved.
We were not privy to the detailed computations of incentive compensation based on cash flow and whether adjustments were made for such nonrecurring items. We did note that in the case of GE, operating cash flow was “adjusted to exclude the effect of unusual events.”
13 However, what constituted such unusual events was not described.
Loan Covenants
Loan covenants are express stipulations included in loan agreements that are designed to monitor corporate performance and restrict corporate acts. Their purpose is to increase the likelihood that principal and interest on loans will be repaid as originally agreed.
Covenants may be positive or negative, although lenders likely will use a combination of the two. Positive loan covenants typically express minimum or maximum financial measures that must be met. For example, a positive loan covenant might call for the borrower to maintain a current ratio (current assets / current liabilities) of 2, or a maximum amount of total liabilities to shareholders’ equity of 1, or a minimum ratio of EBITDA (earnings before interest, taxes depreciation, and amortization) to interest of 5. If a borrower were to fail to meet one or more of these covenants, it would constitute a covenant violation. The lender may agree to waive the violation, on either a temporary or a permanent basis. However, in providing the waiver, the lender has the opportunity to change the loan’s terms, increase its interest rate, seek loan security or guarantees, or even call the loan due.
Negative loan covenants tell a borrower what it cannot do. For example, restrictions may be placed on a firm’s ability to borrow additional funds, pay cash dividends, or make acquisitions.
Loan covenants that employ free cash flow are positive covenants. For example, they may require a firm to generate a minimum amount of free cash flow or to make debt repayments when free cash flow rises above a certain level. Consider, for example, this description of certain covenants found in the debt agreement of National Properties Corp.
The Company has a revolving credit agreement dated February 8, 2001, with Wells Fargo Bank, N.A. The credit facility permits the Company to borrow up to $15,000,000. At December 31, 2003, $11,975,000 ($11,250,000 at December 31, 2002) was outstanding under the agreement and matures on April 30, 2005. . . . The credit agreement contains various covenants, including limitations on additional borrowings and maintaining a minimum free cash flow as defined in the agreement of $1,800,000 per year measured as of the end of each fiscal quarter on an annualized basis. The Company was in compliance with all covenants at December 31, 2003.
14According to the covenants described here, the company is limited in its ability to take on additional borrowings (a negative covenant) and is required to generate a minimum level of free cash flow of $1,800,000 per year (a positive covenant). The company points out that at December 31, 2003, it was in compliance with all of its covenants. By measuring and forecasting free cash flow, an analyst would be able to anticipate a covenant violation.
A loan agreement for IPC Acquisition Corp. also carried a positive covenant based on free cash flow. Consider this statement: “On September 30, 2002, the Company made an excess free cash flow repayment of $30 million based upon 75% of the Company’s free cash flow for the period ended September 30, 2002.”
15 Apparently, the company was required to earmark 75 percent of its free cash flow for loan principal reduction.
In addition to positive debt covenants based on revenue and EBITDA, Motient Corp.’s credit agreement expressly stipulated a minimum amount of free cash flow that must be generated each month. The company’s annual report provided a very detailed description of its progress on meeting or breaching these covenants. The company’s performance results for 2003 are provided in
Exhibit 10.5.
In reviewing the exhibit, it can be seen that when it came to monitoring free cash flow, Motient’s lenders maintained a tight rein on the company. Careful monitoring was necessary because in the past the mobile communications and satellite radio company had experienced difficulty in servicing its debt and found it necessary to file for bankruptcy protection in January 2002.
Exhibit 10.5 Motient Corp., Details of Free Cash Flow Covenant Compliance, Year Ended December 31, 2003 ($ thousands )
Source: Motient Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, Exhibit 10.31, Amendment No. 1 to Amended and Restated Term Credit Agreement, dated March 16, 2004, p. D-2.
During each month of 2003, Motient was presented with a minimum free cash flow amount that was needed to avoid a covenant breach. Note that because the company’s financial results were poor, often the covenant-based minimum free cash flow figures were negative. During most months, the company met its covenant requirement for minimum free cash flow. During some months, the covenant was breached, although the credit agreement had provisions that permitted the company to “bank” free cash flow and meet its covenants on a cumulative basis if they were not met in any one particular month. At the end of 2003, the company noted: “On a cumulative basis, the Company is approximately $4,652,000 ahead of what is required by the covenant plan.”
16
Changing Covenants
Fleetwood Enterprises, Inc., offers an interesting example of a company whose lenders changed to a covenant based on free cash flow and then changed away from that covenant, all within a matter of a few months. During the company’s fiscal year ended April 28, 2002, this covenant change was announced:
Three amendments to the credit agreement were executed during fiscal 2002, mainly to redefine several financial performance covenants. Among the modifications to the credit agreement, the adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) covenant was replaced with a Free Cash Flow covenant.
17With this change, the company replaced its EBITDA covenant with one based on free cash flow. Then, after the end of fiscal 2002, the company’s covenants were changed again.
In July 2002, the facility was further amended, effective as of April 28, 2002, to eliminate the Free Cash Flow covenant as well as a Fixed Charge Coverage Ratio covenant and replace them with a new adjusted EBITDA covenant and a covenant requiring the Company to maintain liquidity (which includes the daily average of cash equivalents and borrowing availability under the credit facility) of at least $80 million.
18Here the free cash flow covenant was replaced with a covenant based again on EBITDA together with a minimum liquidity amount. Apparently, the company’s lenders felt that EBITDA, when combined with a liquidity covenant, provided a more effective means for monitoring the firm’s performance than free cash flow.
A Recent Phenomenon
Like the embrace of free cash flow by other groups, the move by lenders to incorporate free cash flow into loan covenants appears to be a relatively recent phenomenon. Traditionally, bankers have used such debt-service indicators as EBITDA or EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent expense) as positive covenants.
It appears to us that measures of EBITDA or EBITDAR and free cash flow would serve as complementary loan covenants. EBITDA or EBITDAR measure a borrower’s ability to service loan interest. Free cash flow, which typically is measured after interest, taxes, and capital expenditures, provides a measure of cash flow available to repay loan principal. However, if the Fleetwood example is any indication, the trend for lenders to incorporate free cash flow into loan covenants could be short-lived.
Impairment Testing
The value of a long-lived asset or group of assets, such as property, plant, and equipment, capitalized costs, or intangible assets, is impaired when the asset’s carrying amount exceeds its fair value. An impairment loss is recognized, however, only when the carrying amount of the impaired asset is not recoverable. Recoverability is determined by comparing the carrying amount of the asset with the sum of the undiscounted cash flows expected to result from the asset’s use and eventual disposition.
According to SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the relevant accounting standard on the subject of impairment, an asset is evaluated for recoverability when an event or circumstance indicates that the carrying value of the asset may not be recoverable.
19 For example, any of these events or circumstances would call for an evaluation of recoverability:
• A significant decrease in the market price of an asset
• A significant adverse change in the extent or manner in which an asset is being used or in its physical condition
• A significant adverse change in legal factors, regulatory factors or business climate affecting an asset’s market value
• An accumulation of costs significantly in excess of amounts originally expected for the acquisition or construction of an asset
• Current period losses from an asset’s use combined with projections for continuing losses
• An expectation that an asset will be disposed of well before the end of its previously estimated useful life
If one or more of these events or circumstances occurs, management must estimate the total of the undiscounted cash flows expected to result from an evaluated asset’s use and eventual disposition. If the asset’s carrying value exceeds that total, then the fair value of the asset must be estimated and its carrying value written down to that fair value measure.
The specific details of how the amount of an impairment loss is determined—for example, the estimation of fair value—are beyond the scope of this book. Our focus here is on the undiscounted cash flows used in measuring recoverability.
SFAS No. 144 does not refer directly to the use of free cash flow in its test for recoverability. Rather, it refers to cash inflows minus associated cash outflows that are directly associated with the use and eventual disposition of an asset or asset group. Any expected cash inflow would be based on the asset’s service potential. Outflows would include costs incurred to maintain that service potential.
Although SFAS No. 144 does not refer explicitly to the use of free cash flow in determining whether an asset’s carrying value is recoverable, we noted several companies that did use the term. Consider, for example, UnitedGlobalCom, Inc. As noted by the company:
As a result of this revised business plan, we determined that a triggering event had occurred with respect to this investment in the fourth quarter of 2001. . . . After analyzing the projected undiscounted free cash flows (without interest), an impairment charge was deemed necessary.
20Consider also the annual report of Vectren Utility Holdings, Inc., which states:
The Company has investments in . . . notes receivable convertible into equity interests. When events occur that may cause one of these investments to be impaired, the Company performs an impairment analysis. An impairment analysis of notes receivable usually involves the comparison of the investment’s estimated free cash flows to the stated terms of the note.
21We do not think that these companies have misapplied SFAS No. 144 in using free cash flow to determine whether an asset’s carrying value is recoverable. Rather, we think that their descriptions reflect a lack of specificity in the use of the term “free cash flow.” In these examples, the term appears to be used in a generic sense to mean cash flow or, more specifically, the cash inflows directly associated with the use and eventual disposition of the assets in question minus the related cash outflows.
WHAT IS FREE CASH FLOW?
Much of this book has been devoted to the definitions of cash flow, such as operating, investing, and financing cash flow. So where does free cash flow fit in?
Certainly the term “free” does not refer to a lack of price, as in “complimentary” cash flow. Rather, the term “free” refers to an absence of a superior claim. It is cash flow that is available for use with no strings attached. Spending it will not affect the firm’s ability to generate more.
Valmont Industries, Inc., provides an insightful look into how a company planned to use its free cash flow. As stated by the company:
Our priorities in use of future free cash flows are as follows:
• Fund internal growth initiatives in core businesses
• Pay down interest-bearing debt
• Invest in acquisitions clearly connected to our core businesses or an existing competency
• Return money to our shareholders through increased dividends or common stock repurchases at appropriate share prices
22 Valmont’s list of priorities helps make the point that free cash flow is available for use. Company management is free to use it as it sees fit. In the case of Valmont, the company would first increase spending on growth initiatives, then reduce loan principal and invest in acquisitions, and, finally, pay common dividends or use available cash to repurchase stock.
Free to Whom?
Valmont was referring to free cash flow available for common shareholders. However, that is not always the case.
An essay question on the Uniform Certified Public Accountant’s exam that dates from about 30 years ago asked CPA candidates to define net income. The question, however, contained a qualifier. Candidates were asked to define net income for different claimant groups, including lenders, preferred shareholders, and common shareholders. The question wanted to ensure that candidates understood that our traditional definition of net income was income available for shareholders, including preferred and common shareholders, after interest to lenders had been expensed. Preferred dividends needed to be subtracted from net income to derive income available for common shareholders.
As with net income, the definition of free cash flow also requires one to identify a claimant group. As noted earlier, free cash flow might be defined as available for the firm, which would consist of cash flow available for all claimant groups. Alternatively, it might be defined as available for a particular shareholder group, typically the common shareholder. As an example, consider this statement made by DRS Technologies, Inc., a company that defines free cash flow from the viewpoint of the common shareholder: “We disclose free cash flow because we believe that it is a measurement of cash flow generated that is available to common stockholders.”
23 According to the company, free cash flow is available for common shareholders after other superior claims, such as debt holders and preferred shareholders, if any, have been covered.
Free Cash Flow to the Firm
Free cash flow to the firm consists of cash flow provided by operating activities before interest, but after capital expenditures. Cash flow provided by operating activities is defined as cash available for shareholders. Thus, it is computed after income taxes and interest have been paid. In computing free cash flow to the firm, we add back interest to get a measure of cash flow available for all claimants—debt holders, preferred shareholders, and common shareholders. Capital expenditures are subtracted to enable the firm to maintain its productive capacity before cash is considered available for any claimant group.
As an example, refer again to Chapter 1 and the data for Lowe’s Companies, Inc., for the year ended January 31, 2003. That year the company reported cash provided by operating activities of $2,696 million. Interest paid that was subtracted in arriving at operating cash flow totaled $186 million, which, after federal and state taxes, assuming a combined marginal rate of 40 percent, translates into $112 million ($186 million - 40 percent of $186 million).
24 Thus, operating cash flow before interest was $2,808 million ($2,696 million + $112 million). We look more closely at capital expenditures in the calculation of free cash flow in a subsequent section of this chapter. For the time being, we will use actual capital expenditures net of dispositions in our calculations. During the year ended January 31, 2003, net capital expenditures were $2,318 million. Thus, free cash flow to the firm for the year was $490 million ($2,808 million - $2.318 million).
Free Cash Flow to Common Equity
Free cash flow to common equity is computed after the superior claims of debt holders and preferred shareholders have been covered. Its calculation begins with cash provided by operating activities, which is after interest paid has been subtracted. Preferred dividends that have been paid must then be subtracted from operating cash flow to cover that claim. Capital expenditures net of dispositions are subtracted from the remainder to derive free cash flow to common equity.
As an example, we refer again to the amounts for Lowe’s Companies for the year ended January 31, 2003. The company reported cash provided by operating activities of $2,696 million. We subtract net capital expenditures of $2,318 million to obtain free cash flow to common equity of $378 million ($2,696 million - $2,318 million). The company had no preferred equity outstanding and thus paid no preferred dividends.
Free Cash Flow without a Claimant Group Identified
Each of our definitions of free cash flow identifies a claimant group. We identified free cash flow to the firm and free cash flow to common equity. In practice, it is likely that references to free cash flow will not identify a claimant group, referring instead simply to free cash flow.
When a particular claim is not identified, reference typically is being made to free cash flow available for common equity. That also will be the approach taken here. Thus, when we use the term “free cash flow” and a claimant group is not identified, our reference will be to free cash flow available for common shareholders. In addition, because most parties who are interested in free cash flow are interested in the amount that is available for common shareholders, free cash flow to common equity will be our primary focus.
Sustainable Operating Cash Flow
Our calculation of free cash flow, both free cash flow to the firm and free cash flow to common equity, begins with cash provided by operating activities or, more simply, operating cash flow. Much of this book is devoted to the identification and reclassification of certain operating items and the removal of nonrecurring items that may be included in reported operating cash flow. When we employ operating cash flow in the calculation of free cash flow, the assumption is that operating cash flow first has been adjusted to reclassify certain operating items and remove nonrecurring items. The net result is a cleaner, more sustainable, and ultimately more meaningful measure of free cash flow.
Using Net Income to Calculate Free Cash Flow
Often definitions of free cash flow begin with net income. For example, free cash flow to common equity for a firm with no preferred equity outstanding might be defined as:
Free cash flow (to common equity) =
Net income + Depreciation - ΔOperating working capital - Capital expenditures
25This definition of free cash flow is equivalent to our definition, which begins with operating cash flow and subtracts capital expenditures. Net income adjusted for noncash expenses such as depreciation and for changes in operating working capital equals operating cash flow. Once capital expenditures are subtracted, the net result is free cash flow.
What about Changes in Debt Levels?
Some definitions of free cash flow, both to the firm and to common equity, add to free cash flow new borrowings and subtract debt repayments.
26 Such an approach has intuitive appeal if one views new borrowings as being used to finance new capital expenditures. It can be viewed as tantamount to the inclusion in free cash flow of increases in operating liabilities, such as accounts payable and accrued expenses payable, that are used to finance increases in operating assets, such as accounts receivable and inventory.
However, while changes in operating liabilities typically are geared to changes in operating assets, borrowings are less likely to be aligned with capital expenditures. For example, borrowed funds might be used to help pay for an acquisition. Borrowings also might be increased to repurchase common stock. Cash paid for acquisitions or cash used to repurchase stock are not expenditures that are normally subtracted in computing free cash flow. Accordingly, if the related borrowings were included as a source of cash, the computed free cash flow amount would be increased. Moreover, when compared with an equity-financed firm, a company that uses borrowings to pay for capital expenditures would, all else being equal, report higher free cash flow.
27 The problem is that those new borrowings are not “free.” They result in new claims on future cash flow. One additional concern with the inclusion of borrowings in the computation of free cash flow is that a company without operations could generate positive free cash flow simply by borrowing money. Such an outcome is counterintuitive and not in the spirit of the sustainable nature that we think of as free cash flow.
Thus, we are employing a definition of free cash flow that does not include changes in debt levels. That definition for free cash flow to equity is consistent with the majority of definitions of free cash flow seen in practice. The next statement, again from DRS Technologies, Inc., is consistent with this view.
Free cash flow represents cash generated after paying for interest on borrowings, income taxes, capital expenditures and changes in working capital, but before repaying outstanding debt and investing cash to acquire businesses and making other strategic investments. Thus, key assumptions underlying free cash flow are that we will be able to refinance our existing debt when it matures with new debt, and that we will be able to finance any new acquisitions we make by raising new debt or equity capital.
28As seen in the company’s statement, DRS Technologies excludes changes in debt levels in its calculation of free cash flow. However, in calculating free cash flow, the company does make an important assumption that it will be able to refinance debt as it matures and use debt to finance acquisitions. If the company were to have difficulty in refinancing debt or using it to finance acquisitions, its ability to sustain growth in free cash flow could be hampered.
FREE CASH FLOW TO COMMON EQUITY: A CLOSER LOOK
Disclosure of free cash flow is not a GAAP requirement. In addition, free cash flow is not defined by GAAP and is referred to officially as a “non-GAAP measure.” Firms that disclose it must reconcile the measure to the closest GAAP-defined amount, typically operating cash flow. The non-GAAP nature of free cash flow notwithstanding, however, as the measure has gained in notoriety, increasing numbers of companies have opted to calculate and disclose it. As they have, disagreements over the definition of free cash flow have become apparent.
Operating Cash Flow Minus Capital Expenditures
In a survey of reporting practices for free cash flow, the more widely used definition of free cash flow observed in practice was the definition of free cash flow advocated here. For firms without preferred equity outstanding, it is calculated as operating cash flow minus capital expenditures.
Exhibit 10.6 provides a collection of firms that defined free cash flow in this manner.
The companies identified in
Exhibit 10.6 represent a wide collection of nonfinancial firms, including manufacturers such as American Standard Cos., Inc., and NCR Corp., and service firms such as Netflix, Inc., and Yahoo, Inc. The firms also include smaller companies, such as Esco Technologies, Inc., and School Specialty, Inc., and larger concerns, such as Gillette Co. and Raytheon Co.
Although operating cash flow minus capital expenditures was the more common definition of free cash flow noted in practice, some companies used slight variations on that definition. For example, in addition to capital expenditures, some firms subtracted dividends on common stock from operating cash flow in computing free cash flow. Other firms began with operating cash flow and subtracted investing cash flow instead of capital expenditures. A closer look at these alternative definitions is provided next.
Exhibit 10.6 Companies Defining Free Cash Flow as Operating Cash Flow Less Capital Expenditures
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Source |
|---|
| Airgas, Inc. | Form 8-K (July 24, 2003) |
| American Standard Cos., Inc. | Form 8-K (October 15, 2003) |
| Bausch & Lomb, Inc. | Form 10-K (December 28, 2002) |
| Esco Technologies, Inc. | Form 8-K (August 12, 2003) |
| Gillette Co. | Form 10-K (December 31, 2002) |
| Kaydon Corp. | Form 10-K (December 31, 2002) |
| NCR Corp. | Form 10-K (December 31, 2002) |
| Netflix, Inc. | Form 8-K (October 15, 2003) |
| Raytheon Co. | Form 8-K (July 24, 2003) |
| School Specialty, Inc. | Form 8-K (August 12, 2003) |
| Yahoo, Inc. | Form 8-K (January 14, 2004) |
Operating Cash Flow Minus Capital Expenditures and Dividends on Common Stock
In
Exhibit 10.7, we list firms that subtracted from operating cash flow not only capital expenditures but also dividends paid on common stock in computing free cash flow.
We found it interesting that some firms subtracted dividends paid on common stock in computing free cash flow. Free cash flow available to common shareholders should be cash that can be paid out to common shareholders, whether in the form of stock repurchases or dividends, without affecting the company’s ongoing operations or its ability to continue generating more cash flow. In fact, increases in free cash flow can be viewed as evidence of a firm’s ability to increase its common stock dividend. By subtracting dividends already paid on common stock in their computation of free cash flow, the companies listed in
Exhibit 10.7 actually understate their ability to generate cash flow available for common shareholders. Evidence of that potential understatement is presented in
Exhibit 10.8.
Exhibit 10.7 Companies Defining Free Cash Flow as Operating Cash Flow Less Capital Expenditures and Dividends on Common Stock
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Source |
|---|
| Radio Shack Corp. | Form 10-K (December 31, 2002) |
| Rayonier, Inc.a | Form 10-K (December 31, 2002) |
| Rohm & Haas Co. | From 10-K (December 31, 2002) |
| Tyco International, Ltd. | From 8-K (July 29, 2003) |
| a The company noted that dividends were maintained at prior-year levels. |
Exhibit 10.8 Free Cash Flow Computed before and after Dividends on Common Stock ($ millions)
Sources: Company Form 10-K annual report filings with the Securities and Exchange Commission for the year ended December 31, 2003 (September 30, 2003 for Tyco International, Ltd).
In this exhibit we present data on calculated free cash flow both before and after dividends on common stock for the firms that define free cash flow as operating cash flow minus capital expenditures and dividends. As seen in the exhibit, the impact can be significant. For example, in the case of Rohm & Haas, dividends reduced free cash flow by 28.2 percent. For Rayonier, the reduction was 32.5 percent.
Operating Cash Flow Minus Investing Cash Flow
In an interesting twist on the definition of free cash flow, two firms in our survey defined free cash flow as operating cash flow minus investing cash flow. The firms, Federal Express Corp. and Jostens, Inc., are presented in
Exhibit 10.9.
As discussed in Chapter 3, investing cash flow includes capital expenditures. However, it also includes other cash flow that is not necessarily needed in maintaining or growing a firm’s productive infrastructure. For example, investing cash flow includes cash paid for acquisitions of other companies or cash received from their disposition. Investing activities also include cash flow associated with the purchase or sale of investments. Thus, the expansion of the definition of free cash flow to include the effects of investing activities appears to cloud the measure and render it less useful.
Consider Federal Express. In addition to net capital expenditures of $1,222 million, $1,050 million, and $900 million in the years ended May 31, 2001, 2002 and 2003, respectively, other sources and uses of cash were reported among the items classified as investing cash flow. For example, in 2001, the company reported $237 million in proceeds from a sale and leaseback transaction in the investing section. Also, the company reported that it invested $14 million in a business acquisition during 2002. Finally, a classification titled “other, net” resulted in an investing use of cash of $5 million in 2001 and a source of cash of $13 million in 2002. The inclusion of any of these items in the computation of free cash flow is questionable.
Jostens’ use of investing cash flow instead of capital expenditures also can result in a misleading amount of free cash flow. For example in the five-month, postmerger period ending January 3, 2004, in addition to net capital expenditures of $17,034,000, the company reported a $10,936,000 use of cash for the acquisition of businesses and an $18,000 use of cash for “other investing activities.”
Earnings-Based Definitions of Free Cash Flow
Earlier, we indicated that free cash flow defined as net income adjusted for noncash expenses and changes in operating-related working capital, minus capital expenditures, was tantamount to defining free cash flow as operating cash flow minus capital expenditures. However, what is unique about the earnings-based definitions of free cash flow found in the sections that follow is that the companies using them did not make adjustments to remove changes in operating working capital. Thus, their so-called free cash flow is not actually comprised of cash at all.
Exhibit 10.9 Companies Defining Free Cash Flow as Operating Cash Flow Less Investing Cash Flow
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Source |
|---|
| Federal Express Corp. | Form 10-Q (November 30, 2002) |
| Jostens, Inc. | Form 8-K (August 7, 2003) |
Some companies that used an earnings-based definition of free cash flow based it on EBITDA. Others began their calculation of free cash flow with net income. Others started with operating income.
Free Cash Flow Based on EBITDA
Three firms that based their definition of free cash flow on EBITDA are listed in
Exhibit 10.10.
We find defining free cash flow using EBITDA to be troublesome. Because it does not include changes in operating working capital, EBITDA is not cash flow. For example, EBITDA may grow with increases in such working capital accounts as accounts receivable and inventory. But these asset increases do not provide cash.
Even more problematic, however, is the fact that two companies listed in
Exhibit 10.10, DSL Net, Inc., and Western Wireless Corp., did not subtract interest or taxes in their computation of free cash flow. Earnings before interest and taxes are not earnings that are available for common shareholders. That is, interest and taxes must be deducted before earnings are available for shareholders. EBITDA after capital expenditures is more appropriately considered to be an earnings-related figure that is available for debt holders for the payment of interest. However, the two companies in question did not make that distinction.
The definition of free cash flow employed by NTN Communications, Inc., EBITDA minus cash interest, minus investing cash flow and minus financing cash flow, is a curious amalgam. In its 2002 annual report the company noted that “we generated free cash flow (defined as EBITDA less cash interest expense, cash used in investing activities and cash used in financing activities) of $1,120,000, which has covered our business requirements over that period.”
29By starting with EBITDA, the company’s definition of free cash flow suffers from the same shortcomings of EBITDA just mentioned. At least interest paid was subtracted. Moreover, because the company has been losing money for several years, it has paid little in the way of income taxes. In fact, no taxes were paid in 2000 and 2001 and only $11,000 in income taxes were paid in 2002. Thus, the company’s definition of EBITDA is closer to a measure of earnings that are available for common shareholders. However, because changes in operating working capital are excluded, EBITDA does not measure cash flow.
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Definition of Free Cash Flow | Source |
|---|
| DSL Net, Inc. | EBITDA less capital expenditures | Form 8-K (May 13, 2003) |
| NTN Comm., Inc. | EBITDA less cash interest expense, less investing cash flow and less financing cash flow | Form 10-K (December 31, 2002) |
| Western Wireless Corp. | EBITDA less capital expenditures | Form 10-K (December 31, 2002) |
In 2002, by subtracting investing activities, NTN deducted $102,000 in cash paid for the acquisition of a business in its calculation of free cash flow. This item was unique to 2002 and was not reflective of cash needed to maintain and grow productive capacity, as captured well by capital expenditures.
The subtraction of financing cash flow in the calculation of free cash flow is especially curious. During 2002, the company reported a net use of cash for financing activities of $299,000. Most of that amount was for principal payments on capital leases. What is unclear is whether in a prior year the company would have included the proceeds from capital lease financing as a source of free cash flow in a year when the leased assets were included in capital expenditures. As discussed earlier, linking such financing activities with capital expenditures is tantamount to including changes in accounts payable in the definition of free cash flow along with increases in the inventory that those payables were used to purchase. What is counterintuitive here is why the company would include capital expenditures and asset-related borrowings in its calculation of free cash flow but exclude changes in operating working capital.
Change in the Definition of Free Cash Flow In 2002, Hollywood Entertainment Corp. based its definition of free cash flow on EBITDA. The company defined what it termed “discretionary free cash flow” as
EBITDA less cash paid for interest and taxes, less maintenance capital expenditures, but before discretionary investments in expenditures that are not required to maintain existing stores (e.g. investment in new store openings and new product platform roll-outs).
30
In a more recent move, the video-rental company disclosed a change in its EBITDA-BASED definition of free cash flow. The new definition is a more traditional definition comprised of operating cash flow minus capital expenditures, additions to its rental inventory, and intangible assets. The company described its calculation of free cash flow in this way:
Free cash flow is calculated on the Consolidated Statement of Cash Flows as Cash Flow Provided By Operating Activities of $391 million, less Net Purchases of Rental Inventory of $220 million, less Net Purchases of Property and Equipment of $94 million, less the Increase in Intangibles and Other assets.
31
Free Cash Flow Based on Net Income
In
Exhibit 10.11, we identify three firms that based their definition of free cash flow on net income or, in the case of Charter Communications, Inc., operating income minus cash interest paid.
Exhibit 10.11 Companies Defining Free Cash Flow Based on Net Income
Sources: Company filings with the Securities and Exchange Commission on the forms and dates indicated.
| Company | Definition of Free Cash Flow | Source |
|---|
| Alltel Corp. | Net income plus depreciation and amortization less capital expenditures | Form 8-K (July 24, 2003) |
| Charter Comm., Inc. | Income from operations plus depreciation and amortization less interest on cash pay obligations (i.e., interest on debt paid in cash) less purchases of property, plant, and equipment | Form 8-K (July 31, 2003) |
| Regent Comm., Inc. | Net income plus depreciation, amortization and other noncash expenses less maintenance capital expenditures and other noncash income | Form 8-K (August 8, 2003) |
All three firms in the exhibit added back depreciation to obtain a quasi-measure of cash flow. However, because changes in operating working capital were not taken into account, their so-called free cash flow was not actually a measure of cash flow.
Unlike EBITDA, net income is computed after interest and taxes. As a result, net income is a measure of earnings that is available for common shareholders. In the case of Charter Communications, because the company has incurred sustained losses, it has not been in a tax-paying position. Thus, operating income after interest but before taxes is close in amount to net income, which is after taxes. The primary difference between the two would be other income or expense, which could be viewed as nonrecurring and inappropriate for inclusion when measuring free cash flow on a sustainable basis.
Other Definitions of Free Cash Flow
Among all of the firms in our survey, Akamai Technologies, Inc., provided the most unusual definition of free cash flow. The company defined it as the net change in cash and cash equivalents and marketable securities. Such a definition would include in the computation of free cash flow virtually all operating, investing, and financing activities, regardless of origin.
During the quarter ended September 30, 2003, the firm touted its performance on the basis of its definition of free cash flow and announced: “During the third quarter, Akamai achieved positive free cash flow, generating $2.6 million of free cash flow.”
32 During that same period, the company provided $610,000 in positive operating cash flow and reported capital expenditures of $2,082,000. Thus, for the third quarter ended September 30, 2003, Akamai’s free cash flow calculated as operating cash flow minus capital expenditures was - $1,472,000 ($610,000 - $2,082,000). The primary reasons for the difference between the company’s so-called source of free cash flow of $2.6 million and the negative amount computed as operating cash flow less capital expenditures were financing proceeds generated by the sale of stock and the effects of changes in exchange rates on foreign currency cash balances. Neither of these items would appear to provide a sustainable source of free cash flow.
Reconciling Non-GAAP Measures of Free Cash Flow to GAAP-Defined Amounts
There is no GAAP mandate requiring companies to disclose free cash flow. However, if a public company were to disclose free cash flow or any other non-GAAP performance indicator, such as EBITDA or other so-called pro-forma measures, a reconciliation of that measure to the closest GAAP-based measure also must be provided.
33 Given the many definitions of free cash flow seen in practice, these SEC-mandated reconciliations are very helpful in understanding precisely how a company has defined free cash flow.
Consider Bausch & Lomb, Inc., for example. In its 2002 annual report, the company provided this statement:
The company employs free cash flow as a performance metric and has a stated goal to maximize free cash flow, which is defined as cash generated before the payment of dividends, the borrowing or repayment of debt, settlement of minority interest obligations, stock repurchases, the acquisition or divestiture of businesses, the acquisition of intangible assets and the proceeds from the liquidation of certain investments.
34The company notes the importance of free cash flow, which management seeks to maximize. The company’s definition of free cash flow is then provided, but the definition is not particularly clear. What precisely is “cash generated before the payment of dividends, the borrowing or repayment of debt, settlement of minority interest obligations, stock repurchases, the acquisition or divestiture of businesses, the acquisition of intangible assets and the proceeds from the liquidation of certain investments”?
Fortunately, the company provided a reconciliation of its reported free cash flow to the net change in cash and cash equivalents. The company determined that the net change in cash and cash equivalents was the closest GAAP measure to its reported free cash flow. The company’s reconciliation of the change in cash and cash equivalents to free cash flow, as presented in
Exhibit 10.12, provides a reader with a clearer understanding of the company’s definition of free cash flow.
From the exhibit, we see that Bausch & Lomb’s free cash flow excludes cash flow related to all financing activities. We also see that cash flow associated with certain investing activities, particularly cash paid for acquisitions and proceeds from the liquidation of investments, also are excluded. What is left to explain the change in cash and cash equivalents is operating cash flow and capital expenditures. Thus, the company actually is employing the definition of free cash flow advocated here—operating cash flow minus capital expenditures, although that fact was not particularly clear from the company’s stated definition.
As noted, Charter Communications defined free cash flow based on income from operations. The company’s derivation of free cash flow from income from operations and a reconciliation of that amount to GAAP-based operating cash flow for the three months ended June 30, 2002, and 2003 are provided in
Exhibit 10.13.
Exhibit 10.12 Bausch & Lomb, Inc., Reconciliation of Free Cash Flow to Net Change in Cash and Cash Equivalents, Years Ended December 29, 2001, and December 28, 2002 ($ millions)
Source: Bausch & Lomb, Inc. Form 10-K annual report to the Securities and Exchange Commission, December 28, 2002, p. 36.
| 2001 | 2002 |
|---|
| Net change in cash and cash equivalents | $(126) | $ (69) |
| Net cash used in financing activities | 275 | 230 |
| Net cash paid for acquisitions of business and other intangibles, including the $23 sale price adjustment in 2002 | 49 | 30 |
| Proceeds from liquidation of other investments | (97) | — |
| Free cash flow | $ 101 | $191 |
Exhibit 10.13 Charter Communications, Inc., Derivation of Free Cash Flow from Income from Operations and Reconciliation to Net Cash Flows from Operating Activities ($ millions)
Source: Charter Communications, Inc., Form 8-K current report to the Securities and Exchange Commission, July 31, 2003, Addendum, p. 6.
| 2002 | 2003 |
|---|
| Income from operations | $ 85 | $112 |
| Depreciation and amortization | 361 | 377 |
| Option compensation expense, net | 1— | |
| Special charge, net | — | 8 |
| Less: Interest on cash pay obligations | (276) | (281) |
| Less: Purchases of property, plant and equipment | (603) | (160) |
| Free cash flows | (432) | 56 |
| Purchase of property, plant, and equipment | 603 | 160 |
| Special charges, net | — | (8) |
| Other, net | (2) | (2) |
| Change in operating assets and liabilities | (34) | (83) |
| Net cash flows from operating activities | $135 | $123 |
The exhibit demonstrates how Charter Communications derives its definition of free cash flow from income from operations. The primary adjustments consist of depreciation and amortization, interest on so-called cash pay obligations and capital expenditures, referred to here as purchases of property, plant, and equipment.
As discussed earlier, our primary concerns with the company’s definition of free cash flow were its failure to incorporate income taxes and the exclusion of changes in operating working capital accounts. Due to sustained losses, the company did not pay income taxes in the periods presented. Thus, taxes were not a factor to be considered when computing free cash flow. However, changes in operating working capital—that is, changes in operating accounts, typically current assets and liabilities related to operations—were another matter. By excluding such changes, the company’s definition of free cash flow was not truly a measure of cash flow. This fact is highlighted in the required reconciliation of free cash flow to the GAAP-defined net cash flows from operating activities. Note the subtraction in
Exhibit 10.13 of changes in “operating assets and liabilities” in the reconciliation of the company’s free cash flow to net cash flows from operating activities. Without the reconciliation, a reader might not have realized that the company’s definition of free cash flow did not incorporate changes in these accounts.
CAPITAL EXPENDITURES
The preferred definition of free cash flow to common equity employed here is operating cash flow minus capital expenditures and preferred dividends. Given the significance of capital expenditures to free cash flow, it is important to define carefully just what those capital expenditures comprise.
To provide some background, consider this definition of income provided by J. R. Hicks in his book,
Value and Capital, first published in 1939:
A man’s income [is defined] as the maximum value that he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning. 35
Although Hicks’s focus was on income, his thoughts are instructive for considering the meaning of free cash flow and the need to include capital expenditures in its calculation.
Earlier we talked in terms of free cash flow as being available with no strings attached. We said that spending it would not affect a firm’s ability to generate more. This point is key to an understanding of free cash flow and the role of capital expenditures. If we focus on common shareholders, free cash flow should be available for discretionary use without impacting the firm’s ability to continue its generation. Such cash could be paid out in dividends or used to repurchase stock and have no impact on the firm’s ability to continue generating additional sums.
However, before cash can be used for discretionary purposes, the firm’s infrastructure, its productive capacity, must be maintained. Imagine the impact on a firm’s ability to generate future cash flow if equipment were liquidated and the proceeds from sale were paid out as dividends. Certainly future cash flow would decline. It would be tantamount to farmers feeding their families next year’s seed corn.
Productive capacity must be maintained. The need to do so is consistent with Hicks’s view that income is the maximum value that can be consumed during a period (he referred to a week) while remaining as well off at the end of that period as at the beginning. By deducting capital expenditures in computing free cash flow, productive capacity can be maintained. It is for this reason that we see the inclusion of capital expenditures in virtually every definition of free cash flow used in practice.
Replacement versus Actual Capital Expenditures
The next question that arises is whether replacement capital expenditures should be used in computing free cash flow or whether actual capital expenditures should be used. If we refer again to Hicks’s definition of income, it would seem that replacement capital expenditures would be the logical choice. Replacement capital expenditures are designed to replace capital equipment consumed during a period, thus maintaining a firm’s productive capacity. In Hicks’s view, the firm would remain as well off at period’s end as at the beginning.
Consider Rayonier, Inc., for example. The company defines free cash flow as operating cash flow minus capital expenditures and dividends. The amount of capital expenditures used in its calculation is referred to as “custodial” in nature. The firm defines custodial capital expenditures as “capital expenditures to maintain current earnings level over the cycle and to keep facilities and equipment in safe and reliable condition, and in compliance with regulatory requirements.”
36 Such expenditures are just enough to maintain what Rayonier refers to as its current earnings level, which one could infer as maintaining current productive capacity.
Unlike Rayonier, however, most firms that provide a definition of free cash flow subtract actual capital expenditures and not a maintenance-level amount. Support for using actual capital expenditures comes from the notion that, in valuation, a certain growth rate is assumed. As the rate of growth increases, so does the valuation assigned to current free cash flow. If a certain rate of growth is assumed in valuing a firm, then before cash flow is “free,” it must provide for growth in productive capacity and not simply its maintenance. Using a growth-related capital expenditure amount is also consistent with the use of growth-related increases in operating working capital when computing operating cash flow.
Given the importance of growth to valuation and the need to grow productive capacity as operations grow, we advocate the use of actual capital expenditures and not simply maintenance-level amounts when computing free cash flow. Typically actual capital expenditures are more representative of what a firm must invest to grow its productive infrastructure.
Of course, in any year, actual capital expenditures may run unusually high or low, resulting in a less meaningful measure of free cash flow. Thus, if actual capital expenditures were well outside a recent norm, say a two- or three-year average, we would advocate using a normalized amount that relies more heavily on recent average annual expenditures.
Gross versus Net Capital Expenditures
Another nuance in the measurement of capital expenditures for the purpose of calculating free cash flow is whether gross capital expenditures should be used or capital expenditures net of the proceeds from dispositions. Generally accepted accounting principles for cash flow reporting call for the disclosure of gross cash flows. In terms of capital expenditures, that means the separate disclosure of gross capital expenditures and the proceeds from asset dispositions.
For example, during the year ended December 31, 2002, Radio Shack Corp. reported additions to property, plant, and equipment of $106.8 million. The company also disclosed separately that it received $8.6 million in proceeds from the sale of property, plant, and equipment.
37Rayonier reported its capital expenditures in a slightly different fashion. For the year ended December 31, 2002, the company reported net capital expenditures of $76.7 million.
38 However, in a parenthetical disclosure the company noted that $773,000 in proceeds were received from asset sales and retirements.
Not all of the reviewed companies disclosed proceeds received from capital asset dispositions. The likely explanation was that cash received for those dispositions was not material.
In calculating free cash flow, we advocate the use of capital expenditures net of proceeds received for dispositions. Cash received for asset dispositions can be used to make replacements. As such, gross capital expenditures overstate the amount of cash needed to maintain and grow a firm’s productive capacity.
Sale and Leaseback Transactions
As explored more in depth in Chapter 4, sale and leaseback transactions are, in substance, financing events. As such, one would expect to see reported as financing cash flow the proceeds received upon sale of assets that are simultaneously leased back. It is not unusual, however, when leasebacks are classified as operating leases, to see the proceeds received in a sale and leaseback transaction reported as investing cash flow. When sale and leaseback proceeds are reported in this manner, those proceeds should not be subtracted from gross capital expenditures in calculating net capital expenditures. In sale and leaseback transactions, gross capital expenditures do not include the purchase of replacement assets. Accordingly, subtracting the proceeds from asset sales in such cases would tend to understate net capital expenditures.
We would, however, admit to an exception to this recommendation. If a firm routinely purchases assets and then uses sale transactions with operating leasebacks to finance them, operating cash flow and free cash flow will adequately reflect payments made on the firm’s operating leases. This treatment should capture sufficiently the cost of the assets being used in operations and provide a meaningful measure of free cash flow. Netting the sales proceeds from capital expenditures would be appropriate here. However, we do point out that this exception should not apply to isolated sale and leaseback transactions.
Disclosed in the Investing Section
As discussed in Chapter 3, purchases of property, plant, and equipment, known also as capital expenditures, and the disposition of these assets are reported prominently in the investing section of the statement of cash flows. Thus, the investing section of the statement of cash flows is the most convenient place to find the net amount of cash paid for capital expenditures.
Noncash Investing and Financing Activities
As discussed in Chapter 2, an important feature of the statement of cash flows is the separate disclosure of all noncash investing and financing activities outside the primary statement itself. For example, stock issued to make an acquisition or to settle a debt obligation would be disclosed in a supplement to the statement of cash flows as noncash investing and financing activities. Items of property, plant and equipment might also be acquired in noncash investing and financing transactions. For example, assets might be acquired in transactions in which the seller provides financing.
Property, plant, and equipment acquired in noncash investing and financing transactions will not be included with other capital expenditures reported in the body of the statement of cash flows. Thus, there is a real risk that in computing free cash flow, if non-cash investing and financing activities are not reviewed to identify noncash asset purchases, capital expenditures will be understated, overstating free cash flow.
Capital Leases
Common noncash investing and financing transactions that should be included in the calculation of capital expenditures and free cash flow is the acquisition of property, plant, and equipment assets through capital leases. As with other noncash investing and financing activities, assets acquired pursuant to capital leases will not impact capital expenditures reported among investing activities in the body of the statement of cash flows. Although subsequent principal payments on these leases could be viewed as expenditures made for the use of the assets, such payments are reported as financing and not investing uses of cash.
The dollar amounts of assets acquired through capital leases can be significant. Consider, for example, Flowers Foods, Inc. Excerpts from the company’s statement of cash flows are provided in
Exhibit 10.14.
As noted in the exhibit, without incorporating the effects of noncash investing and financing activities, Flowers Foods reported positive free cash flow of $21,234,000 in 2001, $77,715,000 in 2002, and $44,371,000 in 2003. However, the company also disclosed that it acquired assets through noncash capital lease transactions in 2001 and 2003. In 2001, $59,665,000 of assets were acquired through capital leases. In 2003, the amount was $54,815,000. If free cash flow were reduced for these noncash transactions, it would turn decidedly negative.
Exhibit 10.14 Flowers Foods, Inc., Free Cash Flow and Noncash Investing and Financing Activities, Years Ended December 29, 2001, December 28, 2002, and January 3, 2004 (labeled as 2003) ($ thousands)
Source: Flowers Foods, Inc., Form 10-K annual report to the Securities and Exchange Commission, January 3, 2004, p. F-6.
As another example, consider U.S. Oncology, Inc. In the year ended December 31, 2002, the company reported operating cash flow of $150.1 million. That year, net capital expenditures reported in the investing section of the cash flow statement were $59.1 million. No preferred dividends were paid. Thus, in 2002, the company apparently generated $91.0 million ($150.1 million - $59.1 million) of free cash flow. However, in its noncash investing and financing activities, the company disclosed that it sold fixed assets worth $9.7 million and received treasury stock in return. Thus, a more accurate calculation of net capital expenditures would require one to subtract these noncash asset sales. As a result, net capital expenditures would be reduced in 2002 to $49.4 million ($59.1 million - $9.7 million) and free cash flow increased to $100.7 million ($150.1 million - $49.4 million).
What about Operating Leases?
The use of property, plant, and equipment gained through operating leases also will be excluded from capital expenditures reported on the statement of cash flows. However, operating leases entail the payment of rent expense, which is an operating use of cash. Accordingly, by reducing operating cash flow, such rental payments also reduce free cash flow. Thus, unlike capital leases entailing noncash investing and financing activities, unless there is a significant increse in operating lease commitments made in one year, no explicit adjustment is needed for operating leases when computing free cash flow.
Capital Expenditures and Accounts Payable
Capital expenditures made prior to the end of a fiscal year for which payment has not been made is another example of a noncash investing activity. The amount of the purchase is included in property, plant, and equipment and accounts payable on the company’s balance sheet. However, because payment was not made for the acquired items, the purchase amount is not reported on the statement of cash flows. Rather, it is reported among the company’s noncash investing and financing activities.
To illustrate how such noncash investing and financing transactions are reported, consider International Absorbents, Inc. For the year ended January 31, 2004, the company reported net cash flow from operating activities of $1,769,000. The company’s investing cash flow included $6,110,000 for purchases of property, plant, and equipment. That amount was up significantly from $2,910,000 in the year ended January 31, 2003, as the company expanded its productive capacity by the opening of a new manufacturing plant. Also reported as a supplement to the statement of cash flows in what was referred to as noncash investing activities was “increase in property, plant and equipment and accounts payable for purchase of plant and equipment” in the amount of $661,000. That amount represented capital expenditures for which payment had not been made at year-end.
Unless amounts involved are especially material, say of sufficient magnitude to affect cash flow trends, when computing free cash flow, we do not advocate adding to capital expenditures purchases of property, plant, and equipment made with accounts payable. Unlike property, plant, and equipment purchased with capital leases on which payments do not appear among investing activities on the statement of cash flows, subsequent payments of accounts payable for purchases of property, plant, and equipment are included with capital expenditures when those amounts are paid. If purchases of property, plant, and equipment made with accounts payable were added to capital expenditures, there is a real risk that they would be double counted when payment was made in a subsequent period. Accordingly, in computing free cash flow, we recommend waiting until payment is made before including purchases of property, plant, and equipment in capital expenditures. It is a more straightforward practice and one that is consistent with the inclusion in capital expenditures of purchases of property, plant, and equipment when an actual cash disbursement takes place. However, to avoid double counting, if material amounts of property, plant, and equipment purchased with accounts payable are added to capital expenditures in computing free cash flow, the same amount also must be subtracted from capital expenditures in the following year.
ACQUISITIONS AND FREE CASH FLOW
Some analysts would subtract cash paid for acquisitions in the computation of free cash flow. Whether payments for acquisitions should be subtracted depends on how those payments are viewed.
For example, if such payments were viewed as discretionary investments, much like the deployment of cash for investments in bonds or equities, they should not be subtracted in computing free cash flow. In this view, acquisitions are a use of free cash flow but not a use required to generate current levels of free cash flow.
There are cases, however, where companies might be considered to be serial acquirers. Such firms devour others on a regular basis, effecting many acquisitions per year, sometimes many acquisitions per month. Here the answer becomes more difficult. In such cases, growth of operating cash flow and free cash flow may depend more on the acquiring firm’s ability to close numerous acquisitions than its ability to grow its cash flow internally.
We think that during the late 1990s and into the early part of this decade, Tyco International, Ltd. could have been viewed as such a serial-acquiring firm. In the years ended September 30, 1998, 1999, and 2000, Tyco reported that it invested $4.3 billion, $4.9 billion, and $4.8 billion, respectively, in acquisitions. In 2001, cash paid for acquisitions increased to $11.0 billion, before declining to $3.1 billion in 2002. During this time, acquisitions at Tyco were too routine and too much a part of the company’s mode of operations to be ignored in the computation of free cash flow. We would subtract cash paid for them.
It is also important to note that a firm that effects numerous acquisitions may use stock or debt to pay for them, classifying the acquisitions among noncash investing and financing activities. If so, we would subtract the noncash payments made for the acquisitions in computing free cash flow.
SUMMARY
This chapter is designed to provide a deeper understanding of free cash flow. Twelve key points were raised in the chapter:
1. References to free cash flow by companies and the financial press have grown markedly in recent years.
2. Free cash flow has many uses, including share valuation, in computing incentive compensation, in loan covenants, and for determining whether long-lived assets are value impaired.
3. Measuring free cash flow requires identification of superior claims. Free cash flow might be defined as free cash flow to the firm or free cash flow to common equity.
4. Free cash flow to the firm is cash flow provided by operating activities before interest, but after capital expenditures.
5. Free cash flow to common equity is cash flow provided by operating activities after capital expenditures and dividends on preferred stock. This is the preferred definition of free cash flow used here.
6. References to free cash flow that do not identify a claimant group typically refer to free cash flow to common equity.
7. Many definitions of free cash flow to common equity are found in practice. Operating cash flow minus capital expenditures is the more common definition. Other definitions of free cash flow include operating cash flow minus capital expenditures and dividends on common stock, EBITDA minus capital expenditures, and net income minus capital expenditures. For firms that are not paying preferred dividends, operating cash flow minus capital expenditures is consistent with the preferred definition used here.
8. Free cash flow is a non-GAAP measure. When it is disclosed, it must be reconciled to the closest GAAP-defined amount. The reconciliation helps to clarify a company’s definition of free cash flow.
9. A more accurate measure of operating cash flow needed for capital expenditures is capital expenditures net of the proceeds received from asset dispositions.
10. Actual capital expenditures, not just the amount needed to maintain productive capacity, provide the infrastructure needed for growth and should be deducted in computing free cash flow.
11. Because they exclude noncash investing and financing activities, capital expenditures reported in the investing section of the statement of cash flows may understate total capital expenditures.
12. Cash paid for acquisitions should be subtracted in computing free cash flow for companies that routinely and on a regular basis acquire other firms.
NOTES
1 J. Fischer, “Joy of Free Cash Flow,”
The Motley Fool.com, February 29, 2002.
2 A. Rappaport, “Beyond Quarterly Earnings: How to Improve Financial Reporting,”
The Wall Street Journal, March 8, 2004, p. R2.
3 S. Hanke, “Where’s the Cash?”
Forbes, April 12, 2004, p. 230.
4 Borders Group, Inc., Form 10-K annual report to the Securities and Exchange Commission, January 27, 2004, p. 16.
5 B. Curry, a spokesperson for
Amazon.com, Inc., as quoted by N. Wingfield, “Options Move May Be at Expense of Accounting Purists,”
The Wall Street Journal, July 14, 2003, p. C1.
6 Amazon.com, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 22.
7 R. Grantham, “Pinched Delta Gives Bonuses to Execs Last Year,”
The Atlanta Journal-Constitution , March 26, 2003, p. A1.
8 Borders Group, Inc., Form 10-K annual report to the Securities and Exchange Commission, January 28, 2001, p. 13.
9 L. Wei, “This Manager Isn’t Rushing to Buy,”
The Wall Street Journal, August 28, 2002, p. D11. Quote is by Scott Brayman, manager of the Sentinel Small Company Fund. Several variations on this “cash is fact, profit is opinion” quote were found.
10 D. Harrison, “Business Valuation Made Simple,”
Strategic Finance, February, 2003, p. 46.
11 D. Nasaw, “Fund Manager Looks for Strong Free Cash Flow,”
The Wall Street Journal, March 16, 2004, p. C5.
12 General Electric Co., Form DEF 14A, definitive proxy statement filed with the Securities and Exchange Commission, March 2, 2004, p. 22.
14 National Properties Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, Exhibit 13.
15 IPC Acquisition Corp., Form 10-K annual report to the Securities and Exchange Commission, September 30, 2002, p. 42.
16 Motient Corp., Form 10-K annual report to the Securities and Exchange Commission, Exhibit 10.31, Amendment No. 1 to Amended and Restated Term Credit Agreement, dated March 16, 2004, p. D-2.
17 Fleetwood Enterprises, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 72.
19 Statement of Financial Accounting Standards Board,
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (Norwalk, CT: FASB, 2002).
20 UnitedGlobalcom, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 33.
21 Vectren Utility Holdings, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, Exhibit 13.
22 Valmont Industries, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 27, 2003, p. 22.
23 DRS Technologies, Inc., Form 10-K annual report to the Securities and Exchange Commission, March 31, 2003, p. 52.
24 The $186 million was net of $25 million in interest that was capitalized and reported as an investing use of cash.
25 For example, refer to A. Damodaran,
Investment Valuation (New York: John Wiley & Sons, 1996), p. 219.
26 Ibid., pp. 219 and 237.
27 In ibid., p. 103, Damodaran notes that when a levered firm increases debt levels, free cash flow for a levered firm will exceed that of an unlevered firm: “During the period when a firm finances its investments needs disproportionately with debt, the free cash flows to equity of this firm will exceed the free cash flows to equity of a firm that does not have this financing slack.”
28 DRS Technologies, Inc., Form 10-K annual report to the Securities and Exchange Commission, March 31, 2003, p. 52.
29 NTN Communications, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 24.
30 Hollywood Entertainment Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, Item 7.
31 Ibid., Form 8-K current report to the Securities and Exchange Commission, January 29, 2004, Exhibit 99.1.
32 Akamai Technologies, Inc., Form 8-K current report to the Securities and Exchange Commission, October 29, 2003, Exhibit 99.1.
33 Regulation G,
Conditions for Use of Non-GAAP Financial Measures (Washington, DC: Securities and Exchange Commission, 2003).
34 Bausch & Lomb, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 28, 2002, p. 36.
35 J. R. Hicks,
Value and Capital, 2nd ed. (London: Clarendon Press, 1946), p. 172.
36 Rayonier, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, Item 6.
37 Radio Shack Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 33.
38 Rayonier, Inc., Form 10-K annual report, p. F-4.
