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the natural cash flows fit into the classifications of the statement of cash flows.
Inflows are displayed in green and outflows displayed in red:

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The sum of CFF, CFI and CFO is net cash flow. Although net cash flow is almost
impervious to manipulation by management, it is an inferior performance measure
because it includes financing cash flows (CFF), which, depending on a company's
financing activities, can affect net cash flow in a way that is contradictory to actual
operating performance. For example, a profitable company may decide to use its
extra cash to retire long-term debt. In this case, a negative CFF for the cash outlay
to retire debt could plunge net cash flow to zero even though operating performance
is strong. Conversely, a money-losing company can artificially boost net cash flow by
issuing a corporate bond or selling stock. In this case, a positive CFF could offset a
negative operating cash flow (CFO) even though the company's operations are not
performing well.

Now that we have a firm grasp of the structure of natural cash flows and how they
are represented/classified, this section will examine which cash flow measures are
best used for particular analyses. We will also focus on how you can make
adjustments to figures so your analysis isn't distorted by reporting manipulations.

Which Cash Flow Measure Is Best?
You have at least three valid cash flow measures to choose from. Which one is
suitable for you depends on your purpose and whether you are trying to value the
stock or the whole company.

The easiest choice is to pull cash flow from operations (CFO) directly from the
statement of cash flows. This is a popular measure, but it has weaknesses when
used in isolation: it excludes capital expenditures--which are typically required to
maintain the firm's productive capability--and it can be manipulated, as we show

If we are trying to do a valuation or replace an accrual-based earnings measure, the
basic question is "which group/entity does cash flow to?" If we want cash flow to

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shareholders, then we should use 'free cash flow to equity' (FCFE), which is the
analog to net earnings and would be best for a price-to-cash flow ratio (P/CF).

If we want cash flows to all capital investors, we should use 'free cash flow to the
firm' (FCFF). FCFF is similar to the cash generating base used in economic value
added (EVA). In EVA, it's called net operating profit after taxes (NOPAT) or
sometimes net operating profit less adjusted taxes (NOPLAT), but both are
essentially FCFF where adjustments are made to the CFO component.

(*) Cash flow from investment (CFI) is used as an estimate of the level of net capital expenditures
required to maintain and grow the company. The goal is to deduct expenditures needed to fund
"ongoing" growth, and if a better estimate than CFI is available, then it should be used.

Free cash flow to equity (FCFE) equals CFO minus cash flows from investments
(CFI). Why subtract CFI from CFO? Because shareholders care about the cash
available to them after all cash outflows, including long-term investments. CFO can
be boosted merely because the company purchased assets or even another
company. FCFE improves on CFO by counting the cash flows available to
shareholders net of all spending, including investments.

Free cash flow to the firm (FCFF) uses the same formula as FCFE but adds after-tax
interest, which equals interest paid multiplied by [1 “ tax rate]. After-tax interest
paid is added because, in the case of FCFF, we are capturing the total net cash flows
available to both shareholders and lenders. Interest paid (net of the company's tax
deduction) is a cash outflow that we add back to FCFE in order to get a cash flow
that is available to all suppliers of capital.

A Note Regarding Taxes
We do not need to subtract taxes separately from any of the three measures above.
CFO already includes (or, more precisely, is reduced by) taxes paid. We usually do
want after-tax cash flows since taxes are a real, ongoing outflow. Of course, taxes
paid in a year could be abnormal. So for valuation purposes, adjusted CFO or EVA-
type calculations adjust actual taxes paid to produce a more "normal" level of taxes.
For example, a firm might sell a subsidiary for a taxable profit and thereby incur
capital gains, increasing taxes paid for the year. Because this portion of taxes paid is
non-recurring, it could be removed to calculate a normalized tax expense. But this
kind of precision is not always necessary. It is often acceptable to use taxes paid as
they appear in CFO.

Adjusting Cash Flow from Operations (CFO)
Each of the three cash flow measures includes CFO, but we want to capture
sustainable or recurring CFO, that is, the CFO generated by the ongoing business.
For this reason, we often cannot accept CFO as reported in the statement of cash
flows, and generally need to calculate an "adjusted CFO" by removing one-time cash

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flows or other cash flows that are not generated by regular business operations.
Below, we review four kinds of adjustments you should make to reported CFO in
order to capture sustainable cash flows. First, consider a "clean" CFO statement from
Amgen, a company with a reputation for generating robust cash flows:

Amgen shows CFO in the indirect format. Under the indirect format, CFO is derived
from net income with two sets of 'add backs'. First, non-cash expenses, such as
depreciation, are added back because they reduce net income but do not consume
cash. Second, changes to operating (current) balance sheet accounts are added or
subtracted. In Amgen's case, there are five such additions/subtractions that fall
under the label "cash provided by (used in) changes in operating assets and
liabilities": three of these balance-sheet changes subtract from CFO and two of them
add to CFO.

For example, notice that trade receivables (also known as accounts receivable)
reduces CFO by about $255 million: trade receivables is a 'use of cash'. This is
because, as a current asset account, it increased by $255 million during the year.
This $255 million is included in revenue and therefore net income, but the company
hadn't received the cash as of year-end, so the uncollected revenues needed to be
excluded from a cash calculation. Conversely, accounts payable is a 'source of cash'
in Amgen's case. This current-liability account increased by $74 million during the
year; Amgen owes the money (and net income reflects the expense), but the
company temporarily held onto the cash, so its CFO for the period is increased by
$74 million.

We will refer to Amgen's statement to explain the first adjustment you should make
to CFO:

1. Tax benefits of (related to) employee stock options (See #1 on
Amgen CFO statement)

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Amgen's CFO was boosted by almost $269 million because a company gets a
tax deduction when employees exercise non-qualified stock options. As such,
almost 8% of Amgen's CFO is not due to operations and not necessarily
recurring, so the amount of the 8% should be removed from CFO. Although
Amgen's cash flow statement is exceptionally legible, some companies bury
this tax benefit in a footnote.

To review the next two adjustments that must be made to reported CFO, we
will consider Verizon's statement of cash flows below.

2. Unusual changes to working capital accounts (receivables,
inventories and payables) (Refer to #2 on Verizon's CFO statement.)
Although Verizon's statement has many lines, notice that reported CFO is
derived from net income with the same two sets of add backs we explained
above: non-cash expenses are added back to net income and changes to
operating accounts are added to or subtracted from it:

Notice that a change in accounts payable contributed more than $2.6 billion
to reported CFO. In other words, Verizon created more than $2.6 billion in
additional operating cash in 2003 by holding onto vendor bills rather than
paying them. It is not unusual for payables to increase as revenue increases,
but if payables increase at a faster rate than expenses, then the company
effectively creates cash flow by "stretching out" payables to vendors. If these
cash inflows are abnormally high, removing them from CFO is recommended
because they are probably temporary. Specifically, the company could pay
the vendor bills in January, immediately after the end of the fiscal year. If it

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does this, it artificially boosts the current-period CFO by deferring ordinary
cash outflows to a future period.

Judgment should be applied when evaluating changes to working capital
accounts, because there can be good or bad intentions behind cash flow
created by lower levels of working capital. Companies with good intentions
can work to minimize their working capital--they can try to collect receivables
quickly, stretch out payables and minimize their inventory. These good
intentions show up as incremental and therefore sustainable improvements to
working capital.

Companies with bad intentions attempt to temporarily dress-up cash flow
right before the end of the reporting period. Such changes to working capital
accounts are temporary because they will be reversed in the subsequent fiscal
year. These include temporarily withholding vendor bills (which causes a
temporary increase in accounts payable and CFO), cutting deals to collect
receivables before year-end (causing a temporary decrease in receivables and
increase in CFO), or drawing down inventory before the year-end (which
causes a temporary decrease in inventory and increase in CFO). In the case
of receivables, some companies sell their receivables to a third party in a
factoring transaction--which has the effect of temporarily boosting CFO.

3. Capitalized expenditures that should be expensed (outflows in CFI
that should be manually re-classified to CFO) (Refer to #3 on the
Verizon CFO statement.)
Under cash flow from investing (CFI), you can see that Verizon invested
almost $11.9 billion in cash. This cash outflow was classified under CFI rather
than CFO because the money was spent to acquire long-term assets rather
than pay for inventory or current operating expenses. However, on occasion,
this is a judgment call. WorldCom notoriously exploited this discretion by
reclassifying current expenses into investments, and, in a single stroke,
artificially boosting both CFO and earnings.

Verizon chose to include 'capitalized software' in capital expenditures. This
refers to roughly $1 billion in cash spent (based on footnotes) to develop
internal software systems. Companies can choose to classify software
developed for internal use as an expense (reducing CFO) or an investment
(reducing CFI). Microsoft, for example, responsibly classifies all such
development costs as expenses rather than "capitalizing" them into CFI--
which improves the quality of its reported CFO. In Verizon's case, it's
advisable to reclassify the cash outflow into CFO, reducing it by $1 billion.

The main idea here is that, if you are going to rely solely on CFO, you should
check CFI for cash outflows that ought to be reclassified to CFO.

4. One-time (nonrecurring) gains due to dividends received or trading
CFO technically includes two cash flow items that analysts often re-classify
into cash flow from financing (CFF): (1) dividends received from investments
and (2) gains/losses from trading securities (investments that are bought and

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sold for short-term profits). If you find that CFO is boosted significantly by
one or both of these items, they are worth examination. Perhaps the inflows
are sustainable. On the other hand, dividends received are often not due to
the company's core operating business and may not be predictable. And gains
from trading securities are even less sustainable. They are notoriously volatile
and should generally be removed from CFO (unless, of course, they are core
to operations, as with an investment firm). Further, trading gains can be
manipulated: management can easily sell tradable securities for a gain prior
to year-end, thus boosting CFO.

Cash flow from operations (CFO) should be examined for distortions in the following

• Remove gains from tax benefits due to stock option exercises.
• Check for temporary CFO blips due to working capital actions--for e.g.,
withholding payables, "stuffing the channel" to temporarily reduce inventory.
• Check for cash outflows classified under CFI that should be reclassified to
• Check for other one-time CFO blips due to nonrecurring dividends or trading

Aside from being vulnerable to distortions, the major weakness of CFO is that it
excludes capital investment dollars. We can generally overcome this problem by
using free cash flow to equity (FCFE), which includes (or, more precisely, is reduced
by) capital expenditures (CFI). Finally, the weakness of FCFE is that it will change if


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