Cash flows without any adjustment may be misleading because they do not reflect the cash outflows that are necessary for the future existence of a firm. An alternative measure, free cash flow, was developed by Michael Jensen in his theoretical analysis of agency costs and corporate takeovers. In theory, free cash flow is the cash flow left over after the company funds all positive net present value projects. Positive net present value projects are those capital investment projects for which the present value of expected future cash flows exceeds the present value of project outlays, all discounted at the cost of capital. In other words, free cash flow is the cash flow of the firm, less capital expenditures necessary to stay in business (i.e., replacing facilities as necessary) and grow at the expected rate (which requires increases in working capital).



For Your Information: The theory of free cash flow was developed by Jensen to explain behaviors of companies that could not be explained by existing economic theories. Jensen observed that companies that generate free cash flow should disgorge that cash rather than invest the funds in less profitable investments.


There are many ways in which companies can disgorge this excess cash flow, including the payment of cash dividends, the repurchase of stock, and debt issuance in exchange for stock. The debt-for-stock exchange, for example, increases the company’s leverage and future debt obligations, obligating the future use of excess cash flow. If a company does not disgorge this free cash flow, there is the possibility that another company—a company whose cash flows are less than its profitable investment opportunities or a company that is willing to purchase and lever-up the company—will attempt to acquire the free-cash-flow-laden company.

As a case in point, Jensen observed that the oil industry illustrates the case of wasting resources: the free cash flows generated in the 1980s were spent on flow-return exploration and development and on poor diversification attempts through acquisitions. He argues that these companies would have been better off paying these excess cash flows to shareholders through share repurchases or exchanges with debt.

By itself, the fact that a company generates free cash flow is neither good NOR bad. What the company does with this free cash flow is what is important. And this is where it is important to measure the free cash flow as that cash flow in excess of profitable investment opportunities. Consider the simple numerical exercise with the Lie Company and the Lou Company:

                                                                                              Lie                    Lou
                                                                                             Company         Company

Cash flow before capital expenditures                                  $1,000             $1,000
Capital expenditures, positive net present value projects      (750)                (250)
Capital expenditures, negative net present value projects         0                  (500)
Cash flow                                                                                $250               $250
Free cash flow                                                                     $250               $750

These two companies have identical cash flows and the same total capital expenditures. However, the Lie Company spends only on profitable projects (in terms of positive net present value projects), whereas the Lou Company spends on both profitable projects and wasteful projects.

The Lie Company has a flower free cash flow than the Lou company, indicating that they are using the generated cash flows in a more profitable manner. The lesson is that the existence of a high level of free cash flow is not necessarily good—it may simply suggest that the company is either a very good takeover target or the company has the potential for investing in un-profitable investments.


Positive free cash flow may be good or bad news; likewise, negative free cash flow may be good or bad news:


Positive free cash flow:

Good News – The company is generating substantial operating cash flows, beyond those necessary for profitable projects.

Bad News – The company is generating more cash flows than it needs for profitable projects and may waste these cash flows on unprofitable projects.


Negative free cash flow:

Good News – The company has more profitable projects than it has operating cash flows and must rely on external financing to fund these projects.

Bad News – The company is unable to generate sufficient operating cash flows to satisfy its investment needs for future growth.


Therefore, once the free cash flow is calculated, other information [e.g., trends in profitability] must be considered to evaluate the operating performance and financial condition of the firm.


How To Calculate 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 expenditures 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 are attributed to expansion.

Consider Lie Dharma Putra’s property, plant, and equipment for 2008, which comprise some, but not all, of LIE DHARMA’s capital investment:

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 LIE DHARMA’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 LIE DHARMA is expanding? Not necessarily: The additions are at current costs, whereas the dispositions are at historical costs. The additions of $1,679 are less than LIE DHARMA’s depreciation and amortization expense for 2007 of $1,693 million, yet it is not disclosed in the financial reports how much of this latter amount reflects amortization. The amount of necessary capital expenditures is therefore elusive.

Some estimate free cash flow by assuming that all capital expenditures are necessary for the maintenance of the current growth of the company. Though there is little justification in using all expenditures, this is a practical solution to an impractical calculation. This assumption flows us to estimate free cash flows using published financial statements. Another issue in the calculation is defining what truly “free” cash flow is. Generally we think of “freecash flow as being left over 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 [assuming that dividends are a commitment, though not a legal commitment].

There is no one correct method of calculating free cash flow and different analysts may arrive at different estimates of free cash flow for a 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 operations and then deduct capital expenditures. For LIE DHARMA in 2008:

Cash flow from operations         $7,742
Deduct capital expenditures      (1,692)
Free cash flow                            $6,050


Though this approach is rather simple, the cash flow from the operations 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 Lie Dharma Putra:

Cash flow from operations (as reported)      $7,742
Adjustment                                                       392
Cash flow from operations (as adjusted)      $8,134
Deduct capital expenditures                        (1,692)
Free cash flow                                               $6,442


We can relate free cash flow directly to a company’s income. Starting 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 non-cash 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 Lie Dharma Putra for 2008.


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 performance. As an example of these variations, consider the alternative to free cash flow developed by Fitch, a company that rates corporate debt instruments. This cash flow measure, referred to as “Net Free Cash 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.

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 are 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 statement) adjusted for the change in deferred income taxes (from the balance sheets). For Lie Dharma Putra in 2008:

Income tax expense                                       $2,031
Deduct increase in deferred income tax           (389)
Cash taxes                                                      $1,642


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 (at 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 non-cash expenses                    $6,623


Step 4:
Earnings before non-cash 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


In the case of Lie Dharma Putra for 2008:

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 an idea of the unconstrained cash flow of the company. This cash flow measure may be useful from a creditor’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 free cash flow net of dividends] may be an appropriate measure because this represents the cash flow that is reinvested in the company.