How Analysts Can Make an Accurate Presentation of Free Cash Flow

A review of EDGAR filings, the SEC system for which public companies transmit financial information, finds over 90% of reporting companies defining free cash flow as operating cash flow minus capital expenditures Example:

MORRIS TOWNSHIP, N.J., January 28, 2011-- Honeywell (NYSE: HON) today announced full-year 2010 sales increased 8% to $33.4 billion vs. $30.9 billion in 2009. Earnings per share (proforma) were up 12% to $3.00 versus $2.69 in the prior year, excluding the unfavorable impact of the pension mark-to-market adjustment. Reported earnings per share for 2010 were $2.59 versus $2.05 in the prior year. Free cash flow (cash flow from operations less capital expenditures) was a record $3.6 billion (cash flow from operations of $4.2 billion).

Source: Honeywell 8K

Unfortunately, corporate financial reporting does not often provide investors with an accurate assessment of the real free cash flows, and hence adjustments to reported financial statements are required. Free cash flow should be defined as the maximum amount of cash an entity could distribute to shareholders without impairing its rate of growth or through return of capital.

Hence, it is up to the analyst to reclassify those financing and investing activities which are more appropriately operating activities and, as such, would provide (potential) investors with a more realistic indication of the true free cash flow generating capacity of the enterprise. This is true even though classification of a particular activity is prescribed or generally accepted, as we see in the examples below.

Example:

For “payments to noncontrolling interests”, to whom as long as they continue to operate profitable operations may be due cash, payments are classified as financing activities while the purchase of the noncontrolling interests would be classified as an investing activity. Unfortunately, for investors who fail to reclassify the payments to the operating activity section, under the common definition of free cash flow, the reader of the financial statement is left with the impression of exaggerated, and incorrect, free cash flows.

For instance, AmSurg Corporation (AMSG), in partnership with physicians, operates surgery centers, where the partnerships may result in cash payments due the minority owners. Such operating cash payments which may result from profitable locations are as much a cost of doing business as payment of salaries or taxes. In common practice, the company classifies these outflows as Financing Activities, the payments representing “outflows or other distributions to owners”, as set forth under FAS 95.

Under the microscope of free cash flow, where free cash represents the income to shareholders of the common stock, the analyst would need to deduct such outflows, which in AmSurg’s case, is sizeable, accounting for over half of reported Cash Flow from Operating Activities (see below). To do otherwise would seriously misrepresent free cash flows as these payments could not be given to shareholders without impairing capital.

To conclude that AmSurg had free cash flows of $214 MM (we add sale of PPE in the Statement shown) would be incorrect. The analyst would need to reclassify the $130.9 MM as an operating activity from which capital spending and proceeds from PPE would be factored, leaving free cash flow as $83.1 MM, or 37% less than would normally be defined.

At CT Capital, as explained in Security Valuation and Risk Analysis, we also account for overspending in discretionary areas, so that, in the case of AmSurg, we would add $2.7 MM back to free cash flow to account for overspending in its cost of goods sold, which could represent overspending of many items in the production and sales process. We would also deduct half of the share repurchases, or $6.3MM, which represents that amount of cash necessary to maintain a steady share count over the prior year. Share based compensation has a real cost. The other half of the buyback would in fact represent free cash flow. Thus free cash flow for the year would approximate $79.5MM, which would depict the maximum distributable cash available for shareholder distribution, or free cash flow.

When making adjustments to published financial statements, the analyst must also adjust or normalcy of one-time (extraordinary) payments or events. Also, taxes, interest and dividends a firm would classify as an investing or financing activity should most often be melded into operating activities. This will also allow for better comparability.

AmSurg Corp.
Consolidated Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
(In thousands)

		2009				2008				2007
Cash flows from operating activities:
Net earnings		$	181,350			$	165,926			$	150,303
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization			22,927				20,815				18,648
Net loss on sale and impairment of long-lived assets			455				922				724
Share-based compensation			4,068				4,710				4,560
Excess tax benefit from share-based compensation			(32	)			(1,351	)			(3,322	)
Deferred income taxes			14,703				14,729				8,063
Increase (decrease) in cash and cash equivalents, net of effects of acquisitions and dispositions, due to changes in:
Accounts receivable, net			1,494				3,792				(2,300	)
Supplies inventory			(60	)			(83	)			47
Prepaid and other current assets			(733	)			2,344				(2,958	)
Accounts payable			1,289				(1,904	)			962
Accrued expenses and other liabilities			6,666				(487	)			8,128
Other, net			457				283				61
Net cash flows provided by operating activities			232,584				209,696				182,916
Cash flows from investing activities:
Acquisition of interests in surgery centers and related transactions			(95,826	)			(118,671	)			(162,777	)
Acquisition of property and equipment			(19,930	)			(18,379	)			(24,640	)
Proceeds from sale of interests in surgery centers			1,298				3,812				5,433
Repayment of notes receivable			1,666				1,458				2,616
Net cash flows used in investing activities			(112,792	)			(131,780	)			(179,368	)
Cash flows from financing activities:
Proceeds from long-term borrowings			137,178				157,787				178,316
Repayment on long-term borrowings			(116,951	)			(114,788	)			(89,712	)
Distributions to noncontrolling interests			(130,855	)			(118,769	)			(103,545	)
Proceeds from issuance of common stock upon exercise of stock options			201				9,970				17,661
Repurchase of common stock			(12,587	)			(12,413	)			–
Capital contributions and ownership transactions by noncontrolling interests			1,036				582				480
Excess tax benefit from share-based compensation			32				1,351				3,322
Financing cost incurred			(17	)			(41	)			(200	)
Net cash flows (used in) provided by financing activities			(121,963	)			(76,321	)			6,322
Net (decrease) increase in cash and cash equivalents			(2,171	)			1,595				9,870
Cash and cash equivalents, beginning of year			31,548				29,953				20,083