CALCULATING FREE CASH FLOW There is some confusion when this theoretical concept is applied to actual

CALCULATING FREE CASH FLOW There is some confusion when this theoretical concept is applied to actual

companies. The primary difficulty is that the amount of capital expendi- tures necessary to maintain the business at its current rate of growth is generally not known; companies do not report this item and may not even

be able to determine how much of a period’s capital expenditures are attributed to maintenance and how much is attributed to expansion. Consider Procter & Gamble’s property plant and equipment for 2002, which comprise some, but not all, of P&G’s capital investment: 12

Additions to property, plant, and equipment $1,679 million Dispositions of property, plant and equipment

(227) Net change before depreciation

$1,452 million How much of the $1,679 million is for maintaining P&G’s current rate

of growth and how much is for expansion? Though there is a positive net change of $1,452 million, does it mean that P&G is expanding? Not neces- sarily: The additions are at current costs, whereas the dispositions are at his- torical costs. The additions of $1,679 are less than P&G’s depreciation and amortization expense for 2001 of $1,693 million, yet it is not disclosed in the financial reports how much of this latter amount reflects amortization. 13 The amount of necessary capital expenditures is therefore elusive.

Some estimate free cash flow by assuming that all capital expendi- tures are necessary for the maintenance of the current growth of the com- pany. Though there is little justification in using all expenditures, this is a practical solution to an impractical calculation. This assumption allows us to estimate free cash flows using published financial statements.

Another issue in the calculation is defining what is truly “free” cash flow. Generally we think of “free” cash flow as that being leftover after all necessary financing expenditures are paid; this means that free cash flow is after interest on debt is paid. Some calculate free cash flow before such financing expenditures, others calculate free cash flow after interest, and still others calculate free cash flow after both interest and dividends (assum- ing that dividends are a commitment, though not a legal commitment).

There is no one correct method of calculating free cash flow and dif- ferent analysts may arrive at different estimates of free cash flow for a

12 In addition to the traditional capital expenditures (i.e., changes in property, plant, and equipment), P&G also has cash flows related to investment securities and acqui-

sitions. These investments are long-term and are hence part of P&G’s investment ac- tivities cash outflow of $6,835 million.

13 P&G’s depreciation and amortization are reported together as $1,693 million on the statement of cash flows.

FINANCIAL STATEMENT ANALYSIS

company. The problem is that it is impossible to measure free cash flow as dictated by the theory, so many methods have arisen to calculate this cash flow. A simple method is to start with the cash flow from opera- tions and then deduct capital expenditures. For P&G in 2002,

Cash flow from operations

Deduct capital expenditures

Free cash flow

Though this approach is rather simple, the cash flow from the oper- ations amount includes a deduction for interest and other financing expenses. Making an adjustment for the after-tax interest and financing expenses, as we did earlier for Procter & Gamble,

Cash flow from operations (as reported) $7,742 Adjustment

Cash flow from operations (as adjusted) $8,134 Deduct capital expenditures

(1,692) Free cash flow

We can relate free cash flow directly to a company’s income. Start- ing with net income, we can estimate free cash flow using four steps:

Step 1: Determine earnings before interest and taxes (EBIT). Step 2: Calculate earnings before interest but after taxes. Step 3: Adjust for noncash expenses (e.g., depreciation). Step 4: Adjust for capital expenditures and changes in working capital.

Using these four steps, we can calculate the free cash flow for Procter & Gamble for 2002, as shown in Exhibit 24.5.