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We examined the operating cash flow of the S&P 100. Our findings? Surprisingly, there's reason to be optimistic about America's blue chips.
Ronald Fink, CFO Magazine
December 1, 2002
Cheer up, Corporate America. You're in better shape than you look.
That conclusion stems from a recent analysis of operating cash flow for the large-cap, blue-chip companies that make up the Standard & Poor's 100 Stock Index. The analysis was prepared for CFO by Charles W. Mulford, an accounting professor in the DuPree College of Management at the Georgia Institute of Technology, with the help of Michael Ely, an analyst in DuPree's financial analysis lab. It shows that after adjusting for nonrecurring and nonoperating items, operating cash flow for the S&P 100 in 2001 was an average of almost 9 percent higher than reported. That represents a distinct turnaround from the average downward revision of 2 percent that Mulford made to operating cash flow reported in 2000.
To be sure, adjusted operating cash flow for companies at or near the median point of the findings--such as Johnson & Johnson, H.J. Heinz, Black & Decker, The Southern Co., Campbell Soup, and Colgate-Palmolive — was virtually the same as reported both this year and last. But given investors' skepticism about the integrity of corporate reporting, the fact that more companies' cash flows weren't subject to downward revision is reason enough for optimism about the larger picture.
Mulford himself says so, though cautiously. After analyzing the financial statements of each member of the S&P 100 for the past two years to get a clearer picture of their operating cash flow, he says, "I was a little surprised at how many companies looked better, especially in 2001." Adds Mulford, a co-author of the recently published book The Financial Numbers Game: Detecting Creative Accounting Practices, "Maybe things aren't as bad as we thought."
Why focus on operating cash flow when most investors remain fixated on earnings? All things being equal, cash flow presents a clearer picture of a company's actual performance, simply because it reflects money received and paid out during a given interval, whereas earnings are based on all manner of estimates and assumptions. What's more, a growing number of companies have been directing investors' attention toward cash flow from operations, even as more than a few have misreported those results.
Adjusting the Flow
But the need to adjust what companies report as cash flow from operations arises even when they adhere to U.S. generally accepted accounting principles. For one thing, they often draw attention to pro forma numbers in press releases, including and excluding certain items as they see fit. That's no problem in the eyes of the Securities and Exchange Commission, as long as they also provide GAAP numbers and show how pro forma and GAAP performance can be reconciled.
Even under GAAP, though, exactly which activities should be considered part of operating cash flow is often subject to interpretation, and the result is a range of practices. Technology companies such as Cisco Systems Inc. and Lucent Technologies Inc. have long included tax benefits from stock options in operating cash flow, while Microsoft Corp., at least until recently, included them in cash flow from financing. Reporting practices vary in the same way, and for a much wider universe of companies, when it comes to cash flow generated by the securitization of receivables. Yet with corporate scandals drawing so much public attention, any disconnect between accounting practices and economic reality quickly undermines investor confidence.
Then why not cut right to free cash flow, widely considered the purest measure of what's left at the end of the day for lenders (when calculated before interest) and for shareholders (after interest)? In fact, investors are now focusing more closely on this yardstick. While Unisys Corp., for example, uses cash flow from operations as one of its four primary compensation benchmarks for senior management, the company has found investors asking more and more questions about free cash flow — which Unisys is not quite currently producing, despite its recent turnaround efforts and strong operating cash flow after adjustment by Mulford. "We still have a ways to go," admits CFO Janet Brutschea Haugen.
The short answer is that the Financial Accounting Standards Board has come up with no standard means of reporting free cash flow, so efforts to adjust it for nonrecurring items are something of a shot in the dark. At a minimum, then, Mulford's approach seems the most logical starting point for a close look at cash flow.
Granted, FASB has taken some steps to further standardize reporting of cash flow, but Mulford's adjustments suggest that in some cases the movement has been in the wrong direction. The board's Emerging Issues Task Force (EITF), for instance, recently decided that tax benefits from stock options should indeed be reported as cash flow from operations instead of financing activities (which explains Microsoft's change of heart). But Mulford, among others, disagrees with the EITF's thinking here, and subtracts these benefits when adjusting operating cash flow.
Adjustments for stock options and receivables securitization are just the beginning of his rethink. While generally accepted principles require proceeds from dispositions, for example, to be included in cash flow from investing activities, GAAP requires the tax payments and benefits that arise from those transactions to be included in cash flow from operations. However, since the activities that produced those items aren't ongoing, Mulford subtracts such tax benefits from operating cash flow and adds back the tax payments. He also subtracts increases in outstanding payables to the extent they exceed revenue growth by 25 percentage points or more. On the other hand, he adds back expenses such as severance payments related to restructuring and tax payments on gains on discontinued operations.
Some of these changes seem counterintuitive, insofar as expenses reduce cash and gains increase it. But again, when cash collections or payments are nonrecurring or nonoperating, Mulford excludes them, no matter what GAAP has to say about them. HCA Inc.'s case is noteworthy here. Last year, the hospital chain paid the government $900 million, including interest, to settle charges of Medicare billing fraud. That's obviously a considerable expense, and one that GAAP says should be included as a reduction in operating cash flow. But if anything qualifies as nonrecurring, this item should. Accordingly, Mulford added $648 million, the aftertax amount of the settlement, back to HCA's reported operating cash flow in 2001, which accounted for most of the company's 46 percent upward adjustment that year.
Running the Gamut
Of course, the effects of Mulford's adjustments vary widely. The totals for individual companies in 2001 ranged from an upward revision of 509 percent for defense contractor Raytheon Co. to a downward adjustment of 22 percent for technology services provider Schlumberger Ltd. Interestingly enough, several of the 10 companies with the biggest upward adjustments — including J.P. Morgan Chase, Xerox, and Bristol-Myers Squibb, as well as Raytheon and HCA — have labored under a cloud of investor skepticism. Mulford's findings suggest that the skepticism may be unwarranted, or at least overdone.
In Raytheon's case, adjusted cash flow from operations was much better than reported last year, largely because of divestitures, including that in 2000 of its engineering and construction unit, a money-losing business that Wall Street had long been calling on the company to exit. Sure enough, the business produced most of the $635 million in operating cash flow that Mulford added back in 2001 for discontinued operations, helping raise Raytheon's total operating cash flow from a reported $133 million to $810 million. That, to be sure, was about 30 percent less than the $1 billion that Mulford figures was Raytheon's adjusted operating cash flow for 2000, but represented nowhere near as precipitous a decline as that based on reported numbers.
Working the Capital
Why would the effect be felt the year after the sale? The buyer later went bankrupt, leaving Raytheon with continuing liabilities. But those are soon coming to an end, says Franklyn Caine, CFO of Raytheon. In fact, Caine estimates that Raytheon's cash flow from continuing operations this year will soon be much closer to its total, and that it will be sustainable, thanks to more-efficient working capital management. While further improvements in working capital may not be forthcoming, he contends that maintaining the current level will help much more cash fall to the bottom line. "Getting working capital right goes a long way toward sustaining growth," he says.
Or consider Xerox Corp., whose upward adjustment in 2001 operating cash flow of 31 percent followed a sharp downward change the previous year. That reflected additions by Mulford of such nonrecurring items as restructuring expenses and tax payments on nonoperating gains, which Xerox had subtracted to conform to GAAP. While these were offset by a big jump in securitization of receivables the year before, that activity dwindled last year, at least in terms of the amount of receivables actually sold. And the additions for 2001 were large enough to outweigh a subtraction by Mulford for the capitalization of internal software development costs, which he considers an operating expense. Reported cash flow from operations has improved markedly so far in 2002, so the company has been emphasizing the performance measure in its quarterly earnings reports. And while Xerox has been hurt by an accounting scandal over the way it has recognized revenue from sales and leases, analysts who focus on cash flow from operations are relatively sanguine about the company's prospects. "We're poised for very, very positive results," says Xerox CFO Larry Zimmerman, citing much-improved operating margins in the wake of the company's recent restructuring efforts.
The percentage increase in Unisys's operating cash flow for 2001 as a result of Mulford's adjustments was even larger than Xerox's increase, primarily because of a sharp decline in the securitization of receivables. The prior level reflected a desire to reduce the considerable amount of working capital necessary to support the business of supplying routers for network-services customers. Once Unisys downsized that business in late 2000, it reduced securitization. "Unisys prefers to have the cash in-house faster from the customers," Haugen notes, because when you securitize receivables, "you're paid a discount."
At the other end of the spectrum, Mulford figures that nine companies besides Schlumberger produced at least 10 percent less operating cash flow than reported, including such stalwarts as General Electric Co., Microsoft, and Cisco Systems. The latter two's adjustments were primarily the result of their heavy use of stock options to compensate employees. While the deductions companies take in connection with the grants boost reported operating cash flow, Mulford's subtractions for these items are often smaller than that boost, since only part of the benefit is realized in any given year. Based only on Mulford's estimates of those realized benefits, however, both Cisco's and Microsoft's operating cash flow would have fallen by close to $1.5 billion last year, and the adjustments for this item were even larger the previous year.
In GE's case, its payables soared by some 22 percent in 2001, while revenues fell by 3 percent. In Mulford's view, payables cannot continue to increase without a commensurate increase in sales, so when payables growth outpaces revenue growth by more than 25 percentage points, he discounts the amount in excess. There as a consequence went the $3.8 billion boost that vendor reliance provided to GE's stated operating cash flow last year.
Mulford's downward adjustment of Schlumberger's cash flow was also noteworthy. It reflected the capitalization of the cost of client surveys recorded as investment activities, which Mulford considers an operating expense.
Closing the GAAP
Even more innocuous adjustments underscore flaws in GAAP, says Mulford. "While cash flow is considered to be less subject to estimates and assumptions" than earnings, he says, "it isn't immune." Mulford isn't alone in this view. After Enron's meltdown late last year showed how wildly operating cash flow could be gamed, Charles Niemeier, chief accountant of the SEC's enforcement division, complained that companies were abusing standards for defining cash flow. Niemeier has since been nominated to become one of five members of the Public Company Accounting Oversight Board, which the SEC is struggling to set up, and while the Sarbanes-Oxley Act directs that board to oversee audit practices, not accounting standards, Niemeier's complaints may resonate with FASB if investor confidence in corporate reporting isn't soon restored.
Of course, there might be less pressure on FASB to act if enough companies take the accompanying data to heart.
Ronald Fink is a deputy editor at CFO.
Free at Last?
The adjustments to operating cash flow described in the main article naturally affect free cash flow, a measure widely used by analysts engaged in fundamental research. But free cash flow requires some adjustments of its own in the eyes of Georgia Tech accounting professor Charles Mulford. As a result, he undid certain adjustments he'd made for operating cash flow and undertook some additional ones. In the process, he found that free cash flow for the S&P 100 averaged 1 percent less than it would have based on reported numbers last year, versus no change on average the year before.
Unfortunately, it's not possible to compare Mulford's analyses of free cash flow and operating cash flow in aggregate terms, because he excluded financial services firms from the free cash flow analysis. He chose to omit those companies, he explains, because too many extra adjustments would have been necessary to be confident of the findings.
Even on an individual basis, says Mulford, his free cash flow findings shouldn't be relied on too heavily. One reason is that there is no Financial Accounting Standards Board standard for calculating free cash flow. The nonstandard but widely accepted practice seems simple enough at first glance: it calls for subtracting capital expenditures from operating cash flow. But while companies must report capital expenditures, the figures change dramatically from one period to another. What's more, Mulford says it's often difficult to tell whether what companies report for capital expenditures is before or after asset dispositions. As a result, he says, "operating cash flow is a better measure of what is sustainable."
He also says that some of his adjustments to free cash flow are likely to be quite controversial. To arrive at adjusted numbers for free cash, for instance, he subtracts not only capital expenditures, but also restructuring charges and cash flow from acquisitions. He subtracts restructuring charges because they reduce cash available to investors. And he subtracts cash flow from acquisitions because they're needed to grow rather than operate the business. The adjustments for acquisitions are likely to generate the most sparks, says Mulford, as many analysts contend that acquisitions have been fundamental to serial acquirers' business.
Of course, whether acquisitions will happen as regularly in the future as they have in the past is another matter. —R.F.
Adjusting the Flow
See a comparison of reported cash flow versus adjusted cash flow for the S&P 100, 2000-2001. Expanded data for each individual company can be downloaded into a spreadsheet.
More or Less Free
See a comparison of free cash flow versus adjusted free cash flow for the S&P 100, 2000-2001 top gainers and losers.