Value Based Management: The Corporate Response to the Shareholder Revolution

by John D. Martin and J. William Petty

Most managers think a lot about cash flow. They forecast it, worry about it, discuss it with their bankers, and constantly search for ways to improve it. But the concept is not widely understood. Just ask someone to define cash flow, and you will get a wide variety of responses, ranging from the balance in the firm's checking account to some ill-defined cash amount provided by the firm's operations.

The appropriate definition and measurement of a firm's cash flow is driven by the reason for computing the cash flow. That is, how we intend to use the calculation matters. As one choice, we could use the conventional accountant's format, called a cash flow statement. In this statement, the accountant explains what caused the reported change in a firm's cash balance from one balance sheet to the next. Such knowledge, while meaningful for some purposes, has little relevance in managing the firm to create shareholder value. Instead we interested in the investor's perspective as to why cash flows matter. While there is similarity in the computations, the difference in perspective between the accountant and the investor is not merely semantic. The investor wants to know relevant cash flow in order to determine firm value, which is exactly what we want to know as well.

What is the cash flow that matters to the firm's investors? It is the cash that is free and available to provide a return on the investors' capital. Simply stated—after all, it is not a complex matter—free cash flow is the amount that is available for the firm's investors.

In addition, free cash flows are one and the same regardless of whether we view them from the firm's or the investor's perspective. There is an important equality that must be understood if we are to grasp the significance of free cash flows within a valuation context:

The cash flows that are generated through a firm's operations and investments in assets equal the cash flows paid to—and received by—the company's investors.

That is,

Firm's free cash flows = Financing or investors' cash flows

Let's look more closely at measuring free cash flows, first from the firm's perspective and then from the investor's perspective.

A company's free cash flows are equal to its after-tax cash flows from operations less any incremental investments made in the firm's operating assets. Specifically, free cash flows are calculated as follows:

   operating income

+ depreciation and amortization

= earnings before interest, taxes, depreciation and amortization (EBITDA)

- cash tax payments

= after-tax cash flows from operations

- investment (increase) in net operating working capital, which is equal to current assets less non-interest-bearing current liabilities

- investments in fixed assets (capital expenditures) and other long-term assets

= free cash flow

In the foregoing calculation, we add back depreciation because it does not involve a cash payment. Also, the cash tax payments are the actual taxes paid, not the amount accrued in the income statement. Notice, too, that only non-interest-bearing debt, such as accounts payable and accrued wages, are included in computing the increase in net working capital.(1)

To illustrate how to compute free cash flows, consider Johnson & Johnson's 1999 operations, a year in which the company produced $1.78 billion in free cash flow. The makeup of J& J's free cash flow was as follows (billions of dollars):

Thus, in 1999, Johnson & Johnson generated $4.96 billion from operations plus $24 million from nonoperating activity. This amount, however, was reduced by incremental investment in net working capital of $1.6 billion invested in fixed assets and other long-term assets.

What happened to the 1.78 billion in cash flow that Johnson & Johnson produced? Quite simply, this amount was "free" to be paid out to the firm's investors. Determining the amount of cash received by Johnson & Johnson's investors validate this fact.

We can compute the cash flows received by a firm's investors, i.e., the financing cash flows, as follows:

   interest payments to creditors

+ repayment of debt principal

- additional debt issued

+ dividends paid to stockholders

+ share repurchases

- additional stock issued

= financing cash flow

Thus, the financing cash flows are simply the net cash flows paid to the firm's investors, and if negative, the cash flows that are being invested in the firm by the investors. We already know that Johnson & Johnson had $1.78 billion in free cash flow in 1999. We should expect this amount to be equal to the cash flow received by the investors, which is confirmed as follows (billions of dollars):

As already suggested, the firm's free cash flows are always the same as the cash flows remitted to the firm's investors.

To summarize, a company's free cash flow is equal to its cash flow from operations less any additional investments in working capital and long-term assets. Furthermore, a firm's free cash flow is equal to the amount distributed to its investors—thus, the name free cash flow.

We find it interesting that when we present this equality to executives, some do not find it as intriguing and significant as we do. A few will say, "What's the big deal? All we would have to do is change the amount or form of what is being paid to investors and thereby change the free cash flow." While this is true, they fail to understand that the amount and makeup of a firm's free cash flow are not the result of "playing with the numbers." Instead, free cash flows are the consequence of management policies and practices that have implications for investors regarding the firm's value. We should recognize that a firm's free cash flows are the result of operating, investing, and financing decisions, not some ad hoc number that can be manipulated as we want.

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Excerpted from Value Based Management: The Corporate Response to the Shareholder Revolution, HBS Press, 2000.

(1) Non-interest-bearing current liabilities (NIBCLs) are part of the firm's operating cycle as it purchases inventory on credit, sells on credit, pays its accounts payable and accruals, and eventually collects from its customers. Interest-bearing debt, on the other hand, is a source of financing provided by return-seeking investors, and as such is not part of the firm's recurring operating cycle.

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