In the minds of shareholders, free cash flow has been replacing earnings as the gold standard of financial performance metrics. Less easily manipulated than net income, it has become a go-to measurement of a company’s health.
CFOs and other corporate managers are increasingly choosing to mention free cash flow in their financials and define the term there.
But because free cash flow is a metric outside the realm of Generally Accepted Accounting Principles, there’s no standard definition of the term.
“You get a hundred analysts in a room, and they’re going to disagree on how to define free cash flow, and if you get 100 CFOs, they’ll [differ] in their companies’ definitions,” says Charles Mulford, co-author of a new report by the Georgia Tech Financial Analysis Lab that attempts to set up a working definition of the term.
To be sure, the definition of free cash flow stems at least partly from GAAP.
By far the most common meaning used by major corporations today is operating cash flow (a GAAP-defined term) minus capital expenditures. But companies also meld dividends, debt, capital leases, and divestitures of property, plant, and equipment into their calculations as well.
To Mulford, a Georgia Tech accounting professor, doing such things as including dividends on common stock in the definition of free cash flow flies in the face of the conception of the metric he’s held for decades.
Free cash flow, by his lights, is the cash left over to pay for such things as dividends on common stock and share buybacks, rather than them being part of free cash flow themselves.
“If either buybacks or dividends on common [shares] were subtracted in determining free cash flow, that metric would understate the firm’s capacity to generate that cash,” according to the report, “What Is Free Cash Flow?”
Mulford and his co-author, graduate student Allan Mathis, note, however, that only a small number of non-financial companies in the S&P 500 (the basis for their study) subtract dividends paid on their common stock when they calculate free cash flow.
Seeking to align their proposed definition with current corporate practice as well as their own principles, the authors exclude dividends paid on common stock from free cash flow.
Yet they include the dividends paid on preferred stock, arguing that preferred dividends represent “a claim that is superior to the claims of common shareholders” that takes a predictable bite out of a company’s free cash.
The authors also specify that their calculation of free cash flow is based on growth-oriented capex as well as the maintenance capital expense some companies use exclusively.
If companies only invest in maintaining existing equipment rather than also investing in new equipment, for example, they tend to stagnate and risk eventually going out of business, according to Mulford.
Beyond those provisos, however, the authors back the current basic definition for free cash flow as the standard one.
“In summary, we define free cash flow as GAAP-defined operating cash flow, [minus] growth-related, net capital expenditures,” they write, “and [minus] preferred dividends.”
Overall, the number of companies mentioning free cash flow in their 10-Ks and defining it there have risen strongly since the start of this century, according to the report.
In 2017, 121 non-financial S&P 500 corporations mentioned the term “free cash flow” at least once in their 10-Ks, with 61 defining it. For their 2012 fiscal years, 94 companies mentioned the term and 45 defined it. The numbers for 2002 sharply contrasted with what came later: 38 and 19, respectively.
The report attributes the increased importance of free cash flow to Enron, WorldCom, and the other major accounting scandals of the early 2000s.
Those massive frauds prompted investors to search for a measure of corporate financial performance that couldn’t be so easily finagled.
Enter free cash flow.
“While free cash flow, and cash flow in general, isn’t immune to manipulation, it’s less susceptible than earnings,” says Mulford, noting that calculating net income involves a whole lot more estimating than figuring out free cash flow does. And estimating makes it easier for executives to manage the numbers to their companies’ advantage.
“Estimates are everywhere. The collectability of accounts receivable, the obsolescence of inventory — the list is unending,” he adds.
David M. Katz is a freelance writer based in New York.