Sustainable cash flow is recurring cash and is derived from a company’s profitable operations, which is a renewable source. Positive operating cash flow can be generated in the near term and on occasion over extended periods, even in the absence of profitable operations. However, to produce sustainable cash flow, profitable operations are a must. In the subtitle of this post, we speak of uncovering sustainable financial performance. In particular, our interest, which is shared by both equity investors and creditors, is in uncovering sustainable sources of cash flow. Equity investors make projections of such cash flow and assign an appropriate risk-adjusted discount rate in computing their present value. This present value provides an estimate of a company’s current fair or intrinsic value. Lenders, interested in having interest and principal on loans repaid, seek sustainable cash as a source of repayment. Read on…
Witness the extended demise of Eastern Airlines, Inc., through the late 1980s. Before it was liquidated, the company thrashed about for several years losing money on a regular basis. It stayed in business and at times actually generated positive operating cash flow even as it reported losses. The operating cash it generated was the result of significant noncash expenses, such as depreciation on its equipment, the liquidation of working capital accounts, and its ability to convince certain employee groups to accept equity claims, typically preferred stock, in return for services. An end to operations was ultimately necessary as the company’s inability to generate any meaningful profits finally eliminated any prospect it had of meeting its obligations.
Even operating cash flow supported by profitable operations may not be sustainable. For example: operating cash derived from an outsized decline in accounts receivable or a wholesale liquidation of inventory cannot be maintained. Similarly, extending the time period taken to pay vendors will provide an increase in operating cash flow. However, that increase in cash flow is not derived from a recurring source as vendors ultimately will balk at ever-increasing payment periods and demand more timely payment.
Potential problems notwithstanding, among the three classifications on the statement of cash flows [operating, investing, and financing], operating cash flow is derived from a more sustainable source. Moreover, operating cash flow is clearly disclosed and readily accessible in financial statements. Accordingly, operating cash flow is our starting point for identifying sustainable cash flow. It must be stressed, however, that operating cash flow is only our starting point. Numerous adjustments for misclassifications and nonrecurring cash flow items are needed, as discussed in the paragraphs and posts that follow.
Equity Investors and Cash Flow
Equity investors are naturally interested in sustainable cash flow that might be distributed to them. As residual interest holders, common shareholders have the last claim on cash flow. Lenders and preferred shareholders come before them.
As a starting point in computing cash available for common shareholders, operating cash flow is a useful metric because it is calculated after interest payments have been deducted. Such disbursements represent required cash payments to lenders. However, equity investors typically are interested in making other subtractions from operating cash flow as well. A deduction for capital expenditures is common. There is no general agreement on the measure of capital expenditures to be deducted. For example, some investors would argue that gross capital expenditures, which exclude any proceeds from capital equipment disposals, should be used. Others would argue that net capital expenditures is the more realistic measure.
There is also disagreement concerning whether replacement capital expenditures or capital expenditures needed to support expected growth should be used. Replacement capital expenditures are amounts needed to replace productive capacity consumed during a reporting period. That is, before cash can be paid to shareholders, a company needs to maintain its productive capacity. Failure to do so would mean an eventual end to operations.
Replacement capital expenditures are designed to reflect just such a charge. Of course, estimating replacement capital expenditures is not straightforward. Depreciation is often used as an approximation. However, because it is based on older equipment costs, it tends to understate replacement capital expenditures. Because replacement capital expenditures permit only the maintenance of current productive capacity, capital expenditures needed to grow the business are not taken into account.
Many would argue that if a certain rate of growth is assumed in valuing a company’s shares, then capital expenditures adjusted for growth are more meaningful than replacement capital expenditures. Estimating capital expenditures needed to maintain growth is also a challenging endeavor. Many would use actual capital expenditures for this purpose or possibly a normalized measure of actual capital expenditures: for example, an average of actual capital expenditures made over the most recent two- or three-year period.
Besides capital expenditures, any claim on cash flow that is superior to the claims of common shareholders and that has not been previously deducted in arriving at net income should be subtracted from operating cash flow in computing free cash flow. In particular, dividends on preferred stock are such a claim. Just as preferred dividends are subtracted from net income in computing earnings available for common shareholders, preferred dividends paid, which are reported in the financing section of the cash flow statement, also should be subtracted from operating cash flow in computing free cash flow. Lowe’s did not have preferred stock outstanding and, accordingly, paid no preferred dividends.
Lenders and Cash Flow
Lenders’ claims on cash flow precede those of equity investors. Because it is tax deductible, interest is paid with operating cash flow computed before interest and before income taxes are subtracted. EBITDA, earnings before interest, taxes, depreciation, and amortization, is a crude approximation of such pre-interest, pre-tax operating cash flow. It is referred to as a crude measure of cash flow because although it is calculated before two key noncash expenses, depreciation and amortization, it does not adjust for other noncash items, especially changes in working capital accounts. As such, it is really more a measure of working capital, current assets minus current liabilities, generated by operations before interest and taxes.
Working capital generated by operations is not cash generated by operations. Increases in sales that go uncollected contribute to EBITDA by the associated increase in earnings. However, such sales would not increase operating cash flow. Similarly, cash paid to purchase inventory, which remains on hand, would not reduce EBITDA but would reduce operating cash flow. Thus, unless a lender actually is willing to accept accounts receivable or inventory in payment of interest and principal on a loan, EBITDA does not provide an accurate measure of debt-service capacity. Of course, in order to get access to cash, a lender might be able to force a borrower to liquidate its receivables and inventory. However, there is a risk of loss in such a liquidation process.
Equity Investors and EBITDA
During the 1990s, many equity investors became enamored with EBITDA. Companies reporting their results were all too happy to oblige and began reporting pro-forma earnings measures that were based on EBITDA. These moves were understandable as valuations appeared to be less rich when earnings were calculated before interest, taxes, depreciation, and amortization. However, any shareholders who believe the value of a share of stock is a function of EBITDA are misleading themselves. Earnings before interest, taxes, depreciation, and amortization are not earnings that are available for shareholders.
There are key expenses that must be paid before EBITDA-based earnings can be distributed to shareholders. If EBITDA was useful for equity valuation, that use would stem from a positive correlation it may have with reported earnings and to a lesser extent with operating cash flow.
EBITDA is an earnings-based, modified cash flow metric. It is not a true measure of cash flow. We include it in our discussion because it is used in analysis by lenders and equity investors. However, our focus here is in uncovering sustainable sources of cash flow. Accordingly our discussion of EBITDA will not be as extensive as the attention we afford other cash flow measures.
An Unexpected Problem with EBITDA
Because it is an earnings-based measure, EBITDA suffers from many of the same kinds of creative accounting problems that plague net income. These include premature or fictitious revenue recognition, aggressive cost capitalization, and understated accruals, among others.16 However, Global Crossing, Inc. employed an accounting tactic that lowered earnings even as it raised EBITDA.
Moreover, on the surface the company’s accounting move actually sounded conservative because it raised reported debt levels. In 2001, without a change in its underlying lease or credit agreements, Global Crossing modified its accounting for certain of its outstanding operating leases to capital-lease treatment. What the change meant was that operating lease commitments that were heretofore carried off–balance sheet were brought onto the balance sheet along with associated leased assets. Because liabilities were increased with no accompanying increase in shareholders’ equity, balance sheet measures of financial leverage were raised as well.
On the income statement, rent expense on operating leases was replaced with interest expense and amortization on capital leases. In the early years of the company’s outstanding lease terms, such a step would reduce net income. However, because EBITDA is measured before interest and amortization, that measure was actually increased. The company’s motive was to avoid violation of certain debt agreements that carried covenants based on EBITDA. Even though the accounting move altered EBITDA by little more than 1 percent, that was enough to avoid important covenant violations.
Lease classification is supposed to be established when a lease is signed. It is not subject to unilateral change later without alterations to the terms of the underlying lease. That rule did not stop the company, however. Commenting on the tactic, one forensic accountant noted, “It immediately smacks of an attempted manipulation of the financial results”.
Rather than using EBITDA exclusively in their analysis, many lenders use what is referred to as the Uniform Credit Analysis® (UCA®) approach to cash flow analysis.18 Unlike EBITDA, which is an earnings-based, modified cash flow metric, UCA®-defined cash flow is a stricter definition of cash flow. The UCA® format cash flow statement begins with collections resulting from sales made and services provided. From that opening amount, labeled cash from sales, disbursements are deducted based on their importance to operations and priority of cash flow claim. As each disbursement is subtracted from cash collected, a subtotal is calculated that communicates whether cash collections were sufficient to cover that particular disbursement.
For example: disbursements subtracted first from cash from sales are payments for purchases and production of inventory, referred to as cash production costs. Service firms would include payments for services provided in this caption. The remaining subtotal, gross cash profit, measures cash available after all payments for inventory sold or held for sale and services provided are covered. Subtracted from gross cash profit is cash operating expense, which includes sales and marketing, general and administrative, and research and development expenditures. The remaining subtotal, cash after operations, indicates whether a company’s pretax core operations are generating positive operating cash flow.
Cash after operations is adjusted for other cash income or disbursements and income taxes to yield net cash after operations, which for lenders is a key measure of cash flow performance. This subtotal, reported before interest paid, represents operating cash flow that is available for debt service, including interest and principal.
Net cash after operations, the key subtotal indicating debt service capacity as reported on the UCA® cash flow statement, is calculated very much like cash provided by operating activities as disclosed in GAAP-format cash flow statements. The only material difference is that net cash after operations is reported before interest paid but cash provided by operating activities (i.e., GAAP format), more commonly referred to as operating cash flow, is reported after interest paid. A variation on the UCA® format cash flow, a statement we will refer to as a cash flow analysis statement, is a useful analysis tool for equity investors as well as lenders.
Other Measures of “Cash Flow”
Numerous other measures are referred to as cash flow. Like EBITDA, many of them are not actual cash flow measures but rather earnings-based amounts that have some of the features of actual cash flow measures. For example, net income plus depreciation has been referred to by some as “traditional” cash flow. Net income plus depreciation, which also typically includes amortization, is cash flow only to the extent that it is calculated before certain important noncash expenses. However, there are other noncash expenses that are not accounted for, including deferred tax expense, for example. In addition, net income plus depreciation does not include changes in working capital accounts in its calculations.
A popular measure of cash flow in the real estate industry, especially for real estate investment trusts (REITs), is funds from operations (FFO). The National Association of Real Estate Investment Trusts defines FFO as net income or loss computed in accordance with GAAP excluding gains or losses from debt restructuring and sales of property, plus depreciation and amortization of real estate assets. Thus, FFO, like EBITDA, is not a comprehensive cash flow measure. In fact, BRE Properties, Inc., a real estate investment trust specializing in apartment properties, notes that “FFO does not represent cash generated from operating activities . . . and therefore should not be considered a substitute for . . . cash flow from operations as a measure of liquidity”.
Funds from operations is effectively a measure of net income plus depreciation and, accordingly, is more of a measure of earnings than of cash flow. Alluding to this point and to measurement problems with FFO, R. Scott Sellers, chairman and CEO of Archstone-Smith Trust, another apartment REIT, notes:
Our industry is finally moving to the use of an audited performance measurement, earnings per share. This is a tremendous improvement of the substantially flawed funds from operations (FFO). I believe that a performance metric that ignores depreciation— like FFO does—encourages management to make sub-optimal investment decisions and diminishes credibility with investors.
Although Sellers is focusing his attention on earnings and not cash flow, his comments do raise an important point for cash flow measurement. Even though depreciation is a noncash expense, there is a cash disbursement associated with the use of fixed assets in operations. That disbursement, capital expenditures, is reported as an investing item on the cash flow statement and is not a deduction in computing operating cash flow. If he were speaking in terms of cash flow, Sellers would be referring to free cash flow, which is reported net of capital expenditures. It is because of observations like Sellers’s that we have devoted a post to free cash flow.
A variation on net income plus depreciation that captured investors’ attention during the stock market bubble of the late 1990s was cash earnings, computed by adding goodwill amortization to net income. This calculation dated to a time, before the Financial Accounting Standards (SFAS) Board No. 142, “Goodwill and Other Intangible Assets,” when goodwill was still amortized.21 SFAS No. 142, which was effective in 2002, discontinued the amortization of goodwill and other intangible assets with indefinite lives.
During the 1990s, many firms had grown rapidly through acquisition. As a result, their balance sheets carried significant amounts of goodwill, the amortization of which provided a significant earnings drag. That amortization was added back to net income because it was a noncash expense and was not a recurring cost of operations. The resulting cash earnings, however, was not a measure of cash flow but rather net income excluding one particular expense amount. Accordingly, cash earning was really more a measure of earnings and not cash flow.
EBITDA, net income plus depreciation, funds from operations, and cash earnings are all earnings-based measures that have been referred to as cash flow at one time or another. As noted, none of them is truly a cash flow measure. Accordingly, their use in analysis will not be a focus for this post. However, because of their continuing though declining use in practice and in an effort to provide more perspective on the subject of cash flow reporting.