DIFFICULTIES WITH MEASURING CASH FLOW The primary difficulty with measuring a cash flow is that it is a flow:

DIFFICULTIES WITH MEASURING CASH FLOW The primary difficulty with measuring a cash flow is that it is a flow:

Cash flows into the company (cash inflows) and cash flows out of the company (cash outflows). At any point in time there is a stock of cash on hand, but the stock of cash on hand varies among companies because of the size of the company, the cash demands of the business, and a com-

FINANCIAL STATEMENT ANALYSIS

pany’s management of working capital. So what is cash flow? Is it the total amount of cash flowing into the company during a period? Is it the total amount of cash flowing out of the company during a period? Is it the net of the cash inflows and outflows for a period? Well, there is no specific definition of cash flow—and that’s probably why there is so much con- fusion regarding the measurement of cash flow. Ideally, the analyst needs a measure of the company’s operating performance that is compa- rable among companies—something other than net income.

A simple, yet crude method of calculating cash flow requires simply adding noncash expenses (e.g., depreciation and amortization) to the reported net income amount to arrive at cash flow. For example, the estimated cash flow for Procter & Gamble (P&G) for 2002, is:

Estimated cash flow = Net income + depreciation and amortization Estimated cash flow = $4,352 million + 1,693 million = $6,045 million

This amount is not really a cash flow, but simply earnings before depre- ciation and amortization. Is this a cash flow that analysts should use in valuing a company? Though not a cash flow, this estimated cash flow does allow a quick comparison of income across firms that may use dif- ferent depreciation methods and depreciable lives. 1

The problem with this measure is that it ignores the many other sources and uses of cash during the period. Consider the sale of goods for credit. This transaction generates sales for the period. Sales and the accompanying cost of goods sold are reflected in the period’s net income and the estimated cash flow amount. However, until the account receiv- able is collected, there is no cash from this transaction. If collection does not occur until the next period, there is a misalignment of the income and cash flow arising from this transaction. Therefore, the simple esti- mated cash flow ignores some cash flows that, for many companies, are significant.

Another estimate of cash flow that is simple to calculate is EBITDA— earnings before interest, taxes, depreciation, and amortization. However, this measure suffers from the same accrual-accounting bias as the previ- ous measure, which may result in the omission of significant cash flows.

1 An example of the use of this estimate of cash flow, The Value Line Investment Sur- vey, published by Value Line, Inc., reports a cash flow per share amount, calculated

as reported earnings plus depreciation, minus any preferred dividends, stated per share of common stock [ Guide to Using the Value Line Investment Survey, New York: Value Line, Inc., p. 19, available at http://www.valueline.com].

Cash Flow Analysis

Additionally, EBITDA does not consider interest and taxes, which may also be substantial cash outflows for some companies. 2

These two rough estimates of cash flows are used in practice not only for their simplicity, but because they experienced widespread use prior to the disclosure of more detailed information in the statement of cash flows. Currently, the measures of cash flow are wide-ranging, including the simplistic cash flows measures, measures developed from the statement of cash flows, and measures that seek to capture the theo- retical concept of “free cash flow.”