NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used

NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used

in analyses of companies financial condition and operating perfor- mance. As an example of these variations, consider the alternative to free cash flow developed by Fitch IBCA, a company that rates corporate

debt instruments. 14 This cash flow measure, referred to as net free cash 14 See the research reports at http://www.fitchibca.com for descriptions of this

method.

Cash Flow Analysis

flow (NFCF), is free cash flow less interest and other financing costs and taxes. In this approach, free cash flow is defined as earnings before depreciation, interest, and taxes, less capital expenditures. Capital expenditures encompass all capital spending, whether for maintenance or expansion, and no changes in working capital are considered.

EXHIBIT 24.5 Calculation of Procter & Gamble’s Free Cash Flow for 2002, in

Millions*

Step 1: Net income

$4,352 Add taxes

2,031 Add interest

603 Earnings before interest and taxes

$6,986 Step 2:

Earnings before interest and taxes $6,986 Deduct taxes (@35%)

(2,445) Earnings before interest

$4,541 Step 3:

Earnings before interest $4,541 Add depreciation and amortization

1,693 Add increase in deferred taxes

389 Earnings before noncash expenses

$6,623 Step 4:

Earnings before noncash expenses $6,623 Deduct capital expenditures

(1,679) Add decrease in receivables

$ 96 Add decrease in inventories

159 Add cash flows from changes in accounts payable, accrued

expenses, and other liabilities 684 Deduct cash flow from changes in other operating assets and

liabilities (98) Cash flow from change in working capital accounts

841 Free cash flow

$5,785 *Procter & Gamble’s fiscal year ended June 30, 2002. Charges in operating accounts

are taken from Procter & Gamble’s Statement of Cash Flows.

FINANCIAL STATEMENT ANALYSIS

The basic difference between NFCF and free cash flow is that the financing expenses—interest and, in some cases dividends—are deducted. If preferred dividends are perceived as nondiscretionary—that is, investors come to expect the dividends—dividends may be included with the interest commitment to arrive at net free cash flow. Otherwise, dividends are deducted from net free cash flow to produce cash flow. Another difference is that NFCF does not consider changes in working capital in the analysis.

Further, cash taxes are deducted to arrive at net free cash flow. Cash taxes is the income tax expense restated to reflect the actual cash flow related to this obligation, rather than the accrued expense for the period. Cash taxes are the income tax expense (from the income state- ment) adjusted for the change in deferred income taxes (from the bal-

ance sheets). 15 For Procter & Gamble in 2002, Income tax expense

Deduct increase in deferred income tax (389) Cash taxes

In the case of Procter & Gamble for 2002, EBIT

$6,986 Add depreciation and amortization

1,693 Earnings before interest, taxes, depreciation, and amortization $8,679 Deduct capital expenditures

(1,679) Free cash flow

$7,000 Deduct interest

(603) Deduct cash taxes

(1,642) Net free cash flow

$4,755 Deduct cash common dividends

(2,095) Net cash flow

$2,660 The free cash flow amount per this calculation differs from the $5,785

that we calculated earlier for two reasons: Changes in working capital and the deduction of taxes on operating earnings were not considered.

Net cash flow gives the analyst an idea of the unconstrained cash flow of the company. This cash flow measure may be useful from a cred- itor’s perspective in terms of evaluating the company’s ability to fund additional debt. From a shareholder’s perspective, net cash flow (i.e., net

15 Cash taxes require taking the tax expense and either increasing this to reflect any decrease in deferred taxes (that is, the payment this period of tax expense recorded

in a prior period) or decreasing this amount to reflect any increase in deferred taxes (that is, the deferment of some of the tax expense).

Cash Flow Analysis

free cash flow net of dividends) may be an appropriate measure because this represents the cash flow that is reinvested in the company.