Magazine for Senior Financial Executives: Tuning in to cash flow: clarify cash flow from operations and you’ll find reason for optimism about America’s blue chips

Tuning in to cash flow: clarify cash flow from operations and you’ll find reason for optimism about America’s blue chips – Cover Story

Ronald Fink

CHEER UP, CORPORATE AMERICA. YOU’RE IN BETTER SHAPE THAN YOU LOOK.

That conclusion stems from a recent analysis of operating cash flow for the large-cap, blue-chip companies that make up the Standard & Poor’s 100 Stock Index. The analysis was prepared for CFO by Charles W. Mulford, an accounting professor in the DuPree College of Management at the Georgia Institute of Technology, with the help of Michael Ely, an analyst in DuPree’s financial analysis lab. It shows that after adjusting for nonrecurring and nonoperating items, operating cash flow for the S&P 100 in 2001 was an average of almost 9 percent higher than reported. That represents a distinct turnaround from the average downward revision of 4 percent that Mulford made to operating cash flow reported in 2000.

To be sure, adjusted operating cash flow for companies at or near the median point of the findings–such as Johnson & Johnson, H.J. Heinz, Black & Decker, The Southern Co., Campbell Soup, and Colgate-Palmolive–was virtually the same as reported both this year and last. But given investors’ skepticism about the integrity of corporate reporting, the fact that more companies’ cash flows weren’t subject to downward revision is reason enough for optimism about the larger picture.

Mulford himself says so, though cautiously. After analyzing the financial statements of each member of the S&P 100 for the past two years to get a clearer picture of their operating cash flow, he says, “I was a little surprised at how many companies looked better, especially in 2001.” Adds Mulford, a co-author of the recently published book The Financial Numbers Game: Detecting Creative Accounting Practices, “Maybe things aren’t as bad as we thought.”

Why focus on operating cash flow when most investors remain fixated on earnings? All things being equal, cash flow presents a clearer picture of a company’s actual performance, simply because it reflects money received and paid out during a given interval, whereas earnings are based on all manner of estimates and assumptions. What’s more, a growing number of companies have been directing investors’ attention toward cash flow from operations, even as more than a few have misreported those results.

ADJUSTING THE FLOW

But the need to adjust what companies report as cash flow from operations arises even when they adhere to U.S. generally accepted accounting principles. For one thing, they often draw attention to pro forma numbers in press releases, including and excluding certain items as they see fit. That’s no problem in the eyes of the Securities and Exchange Commission, as long as they also provide GAAP numbers and show how pro forma and GAAP performance can be reconciled.

Even under GAAP, though, exactly which activities should be considered part of operating cash flow is often subject to interpretation, and the result is a range of practices. Technology companies such as Cisco Systems Inc. and Lucent Technologies Inc. have long included tax benefits from stock options in operating cash flow, while Microsoft Corp., at least until recently, included them in cash flow from financing. Reporting practices vary in the same way, and for a much wider universe of companies, when it comes to cash flow generated by the securitization of receivables (see “We Can Work It Out: The 2002 Working Capital Survey,” August). Yet with corporate scandals drawing so much public attention, any disconnect between accounting practices and economic reality quickly undermines investor confidence.

Then why not cut right to free cash flow, widely considered the purest measure of what’s left at the end of the day for lenders (when calculated before interest) and for shareholders (after interest)? In fact, investors are now focusing more closely on this yardstick. While Unisys Corp., for example, uses cash flow from operations as one of its four primary compensation benchmarks for senior management, the company has found investors asking more and more questions about free cash flow–which Unisys is not quite currently producing, despite its recent turnaround efforts and strong operating cash flow after adjustment by Mulford. “We still have a ways to go,” admits CFO Janet Brutschea Haugen.

The short answer is that the Financial Accounting Standards Board has come up with no standard means of reporting free cash flow, so efforts to adjust it for nonrecurring items are something of a shot in the dark (see “Free at Last?” facing page). At a minimum, then, Mulford’s approach seems the most logical starting point for a close look at cash flow.

Granted, FASB has taken some steps to further standardize reporting of cash flow, but Mulford’s adjustments suggest that in some cases the movement has been in the wrong direction. The board’s Emerging Issues Task Force (EITF), for instance, recently decided that tax benefits from stock options should indeed be reported as cash flow from operations instead of financing activities (which explains Microsoft’s change of heart). But Mulford, among others, disagrees with the EITE’s thinking here, and subtracts these benefits when adjusting operating cash flow.

Adjustments for stock options and receivables securitization are just the beginning of his rethink (see chart, page 49). While generally accepted principles require proceeds from dispositions, for example, to be included in cash flow from investing activities, GAAP requires the tax payments and benefits that arise from those transactions to be included in cash flow from operations. However, since the activities that produced those items aren’t ongoing, Mulford subtracts such tax benefits from operating cash flow and adds back the tax payments. He also subtracts increases in outstanding payables to the extent they exceed revenue growth by 25 percentage points or more. On the other hand, he adds back expenses such as severance payments related to restructuring and tax payments on gains on discontinued operations.

Some of these changes seem counterintuitive, insofar as expenses reduce cash and gains increase it. But again, when cash collections or payments are nonrecurring or nonoperating, Mulford excludes them, no matter what GAAP has to say about them. HCA Inc.’s case is noteworthy here. Last year, the hospital chain paid the government $900 million, including interest, to settle charges of Medicare billing fraud. That’s obviously a considerable expense, and one that GAAP says should be included as a reduction in operating cash flow. But if anything qualifies as nonrecurring, this item should. Accordingly, Mulford added $648 million, the aftertax amount of the settlement, back to HCA’s reported operating cash flow in 2001, which accounted for most of the company’s 46 percent upward adjustment that year.

RUNNING THE GAMUT

Of course, the effects of Mulford’s adjustments vary widely. The totals for individual companies in 2001 ranged from an upward revision of 509 percent for defense contractor Raytheon Co. to a downward adjustment of 22 percent for technology services provider Schlumberger Ltd. Interestingly enough, several of the 10 companies with the biggest upward adjustments–including J.P. Morgan Chase, Xerox, and Bristol-Myers Squibb, as well as Raytheon and HCA–have labored under a cloud of investor skepticism. Mulford’s findings suggest that the skepticism may be unwarranted, or at least overdone.

In Raytheon’s case, adjusted cash flow from operations was much better than reported last year, largely because of divestitures, including that in 2000 of its engineering and construction unit, a money-losing business that Wall Street had long been calling on the company to exit. Sure enough, the business produced most of the $635 million in operating cash flow that Mulford added back in 2001 for discontinued operations, helping raise Raytheon’s total operating cash flow from a reported $133 million to $810 million. That, to be sure, was about 30 percent less than the $1 billion that Mulford figures was Raytheon’s adjusted operating cash flow for 2000, but represented nowhere near as precipitous a decline as that based on reported numbers.

WORKING THE CAPITAL

Why would the effect be felt the year after the sale? The buyer later went bankrupt, leaving Raytheon with continuing liabilities. But those are soon coming to an end, says Franklyn Caine, CFO of Raytheon. In fact, Caine estimates that Raytheon’s cash flow from continuing operations this year will soon be much closer to its total, and that it will be sustainable, thanks to more-efficient working capital management. While further improvements in working capital may not be forthcoming, he contends that maintaining the current level will help much more cash fall to the bottom line. “Getting working capital right goes along way toward sustaining growth,” he says.

Or consider Xerox Corp., whose upward adjustment in 2001 operating cash flow of 31 percent followed a sharp downward change the previous year. That reflected additions by Mulford of such nonrecurring items as restructuring expenses and tax payments on nonoperating gains, which Xerox had subtracted to conform to GAAP. While these were offset by a big jump in securitization of receivables the year before, that activity dwindled last year, at least in terms of the amount of receivables actually sold. And the additions for 2001 were large enough to outweigh a subtraction by Mulford for the capitalization of internal software development costs, which he considers an operating expense. Reported cash flow from operations has improved markedly so far in 2002, so the company has been emphasizing the performance measure in its quarterly earnings reports. And while Xerox has been hurt by an accounting scandal over the way it has recognized revenue from sales and leases, analysts who focus on cash flow from operations a re relatively sanguine about the company’s prospects. “We’re poised for very, very positive results,” says Xerox CFO Larry Zimmerman, citing much-improved operating margins in the wake of the company’s recent restructuring efforts.

The percentage increase in Unisys’s operating cash flow for 2001 as a result of Mulford’s adjustments was even larger than Xerox’s increase, primarily because of a sharp decline in the securitization of receivables. The prior level reflected a desire to reduce the considerable amount of working capital necessary to support the business of supplying routers for network-services customers. Once Unisys downsized that business in late 2000, it reduced securitization. “Unisys prefers to have the cash in-house faster from the customers,” Haugen notes, because when you securitize receivables, “you’re paid a discount.”

At the other end of the spectrum, Mulford figures that nine companies besides Schlumberger produced at least 10 percent less operating cash flow than reported, including such stalwarts as General Electric Co., Microsoft, and Cisco Systems. The latter two’s adjustments were primarily the result of their heavy use of stock options to compensate employees. While the deductions companies take in connection with the grants boost reported operating cash flow, Mulford’s subtractions for these items are often smaller than that boost, since only part of the benefit is realized in any given year. Based only on Mulford’s estimates of those realized benefits, however, both Cisco’s and Microsoft’s operating cash flow would have fallen by close to $1.5 billion last year, and the adjustments for this item were even larger the previous year.

In GE’s case, its payables soared by some 22 percent in 2001, while revenues fell by 3 percent. In Mulford’s view, payables cannot continue to increase without a commensurate increase in sales, so when payables growth outpaces revenue growth by more than 25 percentage points, he discounts the amount in excess. There as a consequence went the $3.8 billion boost that vendor reliance provided to GE’S stated operating cash flow last year.

Mulford’s downward adjustment of Schlumberger’s cash flow was also noteworthy. It reflected the capitalization of the cost of client surveys recorded as investment activities, which Mulford considers an operating expense.

CLOSING THE GAAP

Even more innocuous adjustments underscore flaws in GAAP, says Mulford. “While cash flow is considered to be less subject to estimates and assumptions” than earnings, he says, “it isn’t immune.” Mulford isn’t alone in this view. After Enron’s meltdown late last year showed how wildly operating cash flow could be gamed, Charles Niemeier, chief accountant of the SEC’S enforcement division, complained that companies were abusing standards for defining cash flow. Niemeier has since been n ominated to become one of five members of the Public Company Accounting Oversight Board, which the SEC is struggling to set up, and while the Sarbanes-Oxley Act directs that board to oversee audit practices, not accounting standards, Niemeier’s complaints may resonate with FASB if investor confidence in corporate reporting isn’t soon restored.

Of course, there might be less pressure on FASB to act if enough companies take the accompanying data to heart. For more information on individual companies’ adjustments, go to www.cfo.com.

ADJUSTING THE FLOW

Comparing reported cash flow with adjusted cash flow for the S&P 100,

2000-2001

2001 2001

Reported Adjusted

Operating Operating

Company Cash Flow Cash Flow

1. Raytheon 133 810

2. DuPont 2,419 5,072

3. Unisys 202 362

4. HCA 1,413 2,061

5. J.P. Morgan Chase (3,107) (2,119)

6. Xerox 1,566 2,045

7. Bristol-Myers Squibb 5,402 7,039

8. U.S. Bancorp 2,182 2,757

9. Medtronic 1,590 1,989

10. Dow Chemical 1,789 2,234

11. Sara Lee 1,496 1,854

12. Honeywell International 1,996 2,348

13. Norfolk Southern 654 755

14. Toys “R” Us 504 575

15. Pharmacia 1,899 2,152

16. International Paper 1,714 1,934

17. Delta Air Lines 236 264

18. Texas Instruments 1,819 2,012

19. Rockwell International 335 369

20. Hewlett-Packard 2,561 2,803

21. Nextel Communications 1,129 1,221

22. Philip Morris 8,893 9,618

23. American Electric Power 2,953 3,191

24. Clear Channel Communications 610 658

25. Limited 969 1,039

26. Computer Sciences 1,305 1,382

27. Coca-Cola 4,110 4,351

28. Pfizer 9,291 9,779

29. Procter & Gamble 5,804 6,048

30. 3M 3,078 3,206

31. American International Group 7,710 7,984

32. Cigna 1,086 1,118

33. Alcoa 2,411 2,464

34. American Express 5,324 5,415

35. Baker Hughes 721 733

36. Sears, Roebuck 2,262 2,300

37. Bank of America (12,826) (12,649)

38. SBC Communications 14,850 14,999

39. United Technologies 2,885 2,920

40. Allegheny Technologies 123 124

41. Bank One 2,375 2,396

42. Walt Disney 3,048 3,074

43. AT&T 10,558 10,649

44. PepsiCo 4,201 4,219

45. Burlington Northern Santa Fe 2,197 2,201

46. Entergy 2,216 2,218

47. Johnson & Johnson 8,864 8,870

48. Black & Decker 379 379

49. H.J. Heinz 891 891

50. Southern 2,384 2,384

51. Campbell Soup 1,106 1,104

52. Colgate-Palmolive 1,600 1,597

53. Goldman Sachs Group (15,176) (15,210)

54. Merck 9,080 9,057

55. Anheuser-Busch 2,361 2,351

56. Viacom 3,509 3,494

57. Eastman Kodak 2,065 2,054

58. FedEx 2,228 2,211

59. Wal-Mart Stores 10,260 10,178

60. May Department Stores 1,644 1,631

61. Boise Cascade 408 404

62. Williams 1,783 1,767

63. Verizon Communications 19,773 19,578

64. Boeing 3,814 3,771

65. Exxon Mobil 22,889 22,624

66. General Motors 9,166 9,055

67. Tyco International 6,665 6,580

68. McDonald’s 2,688 2,651

69. IBM 14,265 14,009

70. Halliburton 1,029 1,010

71. General Dynamics 1,103 1,082

72. Morgan Stanley Dean Witter (24,091) (24,562)

73. Weyerhauser 1,118 1,094

74. MedImmune 251 244

75. RadioShack 776 755

76. El Paso 4,120 4,005

77. Citigroup 26,578 25,791

78. Oracle 3,243 3,144

79. Hartford Financial Services Group 2,303 2,228

80. Wells Fargo (11,226) (11,648)

81. Harrah’s Entertainment 774 740

82. Ford Motor 22,764 21,728

83. Gillette 2,092 1,987

84. Avon Products 755 717

85. AOL Time Warner 5,294 5,024

86. Lehman Brothers Holdings 6,679 6,332

87. Merrill Lynch 6,421 6,020

88. Exelon 3,615 3,334

89. Amgen 1,480 1,347

90. Lucent Technologies (3,421) (3,756)

91. Baxter International 1,149 1,033

92. General Electric 32,195 28,803

93. AES 1,691 1,512

94. National Semiconductor 100 89

95. Cisco Systems 6,392 5,414

96. EMC 1,631 1,371

97. Microsoft 13,422 11,071

98. Intel 8,654 7,009

99. Home Depot 5,963 4,789

100. Schlumberger 1,568 1,227

2001 2000

% Adjustment Reported

Improved/ Opearting

Company Worsened Cash Flow

1. Raytheon 509.1 960

2. DuPont 109.7 5,070

3. Unisys 79.4 420

4. HCA 45.8 1,547

5. J.P. Morgan Chase 31.8 (13,676)

6. Xerox 30.6 207

7. Bristol-Myers Squibb 30.3 4,652

8. U.S. Bancorp 26.4 4,443

9. Medtronic 25.1 1,832

10. Dow Chemical 24.9 1,691

11. Sara Lee 23.9 1,540

12. Honeywell International 17.6 1,989

13. Norfolk Southern 15.4 1,342

14. Toys “R” Us 14.2 (151)

15. Pharmacia 13.3 1,002

16. International Paper 12.8 2,430

17. Delta Air Lines 11.8 2,898

18. Texas Instruments 10.6 2,185

19. Rockwell International 10.0 645

20. Hewlett-Packard 9.4 3,705

21. Nextel Communications 8.2 576

22. Philip Morris 8.2 11,044

23. American Electric Power 8.0 1,433

24. Clear Channel Communications 7.9 755

25. Limited 7.2 769

26. Computer Sciences 5.9 854

27. Coca-Cola 5.9 3,585

28. Pfizer 5.3 6,195

29. Procter & Gamble 4.2 4,675

30. 3M 4.2 2,326

31. American International Group 3.6 9,081

32. Cigna 3.0 1,685

33. Alcoa 2.2 2,851

34. American Express 1.7 6,353

35. Baker Hughes 1.7 564

36. Sears, Roebuck 1.7 2,702

37. Bank of America 1.4 3,734

38. SBC Communications 1.3 14,066

39. United Technologies 1.2 2,503

40. Allegheny Technologies 0.9 136

41. Bank One 0.9 16,824

42. Walt Disney 0.9 3,755

43. AT&T 0.9 11,665

44. PepsiCo 0.4 4,440

45. Burlington Northern Santa Fe 0.2 2,317

46. Entergy 0.1 1,968

47. Johnson & Johnson 0.1 6,903

48. Black & Decker 0.0 350

49. H.J. Heinz 0.0 506

50. Southern 0.0 2,376

51. Campbell Soup -0.2 1,165

52. Colgate-Palmolive -0.2 1,536

53. Goldman Sachs Group -0.2 11,135

54. Merck -0.3 7,687

55. Anheuser-Busch -0.4 2,258

56. Viacom -0.4 2,323

57. Eastman Kodak -0.5 982

58. FedEx -0.8 2,044

59. Wal-Mart Stores -0.8 9,604

60. May Department Stores -0.8 1,346

61. Boise Cascade -0.9 549

62. Williams -0.9 594

63. Verizon Communications -1.0 15,827

64. Boeing -1.1 5,942

65. Exxon Mobil -1.2 22,937

66. General Motors -1.2 19,750

67. Tyco International -1.3 5,275

68. McDonald’s -1.4 2,752

69. IBM -1.8 9,274

70. Halliburton -1.8 (57)

71. General Dynamics -1.9 1,071

72. Morgan Stanley Dean Witter -2.0 (2,383)

73. Weyerhauser -2.1 1,454

74. MedImmune -2.6 173

75. RadioShack -2.7 117

76. El Paso -2.8 99

77. Citigroup -3.0 2,673

78. Oracle -3.0 2,179

79. Hartford Financial Services Group -3.3 2,435

80. Wells Fargo -3.8 5,569

81. Harrah’s Entertainment -4.4 548

82. Ford Motor -4.6 34,338

83. Gillette -5.0 1,604

84. Avon Products -5.0 324

85. AOL Time Warner -5.1 4,644

86. Lehman Brothers Holdings -5.2 (14,733)

87. Merrill Lynch -6.2 1,304

88. Exelon -7.8 1,096

89. Amgen -9.0 1,635

90. Lucent Technologies -9.8 (703)

91. Baxter International -10.1 1,214

92. General Electric -10.5 22,690

93. AES -10.6 506

94. National Semiconductor -11.0 488

95. Cisco Systems -15.3 6,141

96. EMC -15.9 2,109

97. Microsoft -17.5 11,426

98. Intel -19.0 12,827

99. Home Depot -19.7 2,796

100. Schlumberger -21.8 1,645

2000 2000

Adjusted % Adjusted

Operating Improved/

Company Cash Flow Worsened

1. Raytheon 1,146 19.3

2. DuPont 4,474 -11.8

3. Unisys 194 -53.7

4. HCA 1,588 2.6

5. J.P. Morgan Chase (13,382) 2.2

6. Xerox 19 -90.8

7. Bristol-Myers Squibb 4,392 -5.6

8. U.S. Bancorp 4,690 5.6

9. Medtronic 2,003 9.3

10. Dow Chemical 1,787 5.7

11. Sara Lee 1,389 -9.8

12. Honeywell International 2,332 17.2

13. Norfolk Southern 1,004 -25.2

14. Toys “R” Us (38) 74.8

15. Pharmacia 1,525 52.2

16. International Paper 2,823 16.2

17. Delta Air Lines 2,981 2.9

18. Texas Instruments 2,837 29.8

19. Rockwell International 650 0.8

20. Hewlett-Packard 2,322 -37.3

21. Nextel Communications 588 2.0

22. Philip Morris 11,147 0.9

23. American Electric Power 1,590 10.9

24. Clear Channel Communications 1,075 42.4

25. Limited 769 0.0

26. Computer Sciences 863 1.0

27. Coca-Cola 3,725 3.9

28. Pfizer 8,014 29.4

29. Procter & Gamble 4,880 4.4

30. 3M 2,342 0.7

31. American International Group 8,925 -1.7

32. Cigna 1,723 2.3

33. Alcoa 2,841 -0.4

34. American Express 6,353 0.0

35. Baker Hughes 561 -0.6

36. Sears, Roebuck 2,720 0.7

37. Bank of America 3,743 0.2

38. SBC Communications 15,121 7.5

39. United Technologies 2,419 -0.5

40. Allegheny Technologies 151 10.7

41. Bank One 16,735 -0.5

42. Walt Disney 3,675 -2.1

43. AT&T 12,324 5.6

44. PepsiCo 4,330 -2.5

45. Burlington Northern Santa Fe 2,286 -1.3

46. Entergy 1,573 -20.1

47. Johnson & Johnson 6,883 -0.3

48. Black & Decker 356 1.8

49. H.J. Heinz 500 -1.1

50. Southern 2,376 0.0

51. Campbell Soup 1,161 -0.3

52. Colgate-Palmolive 1,543 0.5

53. Goldman Sachs Group 11,019 -1.0

54. Merck 7,149 -7.0

55. Anheuser-Busch 2,238 -0.9

56. Viacom 1,798 -22.6

57. Eastman Kodak 999 1.8

58. FedEx 2,027 -0.8

59. Wal-Mart Stores 9,546 -0.6

60. May Department Stores 1,336 -0.8

61. Boise Cascade 486 -11.5

62. Williams 544 -8.5

63. Verizon Communications 17,478 10.4

64. Boeing 5,904 -0.6

65. Exxon Mobil 23,242 1.3

66. General Motors 20,374 3.2

67. Tyco International 5,111 -3.1

68. McDonald’s 2,748 -0.1

69. IBM 7,490 -19.2

70. Halliburton (64) -12.3

71. General Dynamics 1,036 -3.3

72. Morgan Stanley Dean Witter (2,370) 0.6

73. Weyerhauser 1,401 -3.7

74. MedImmune 173 0.1

75. RadioShack 117 0.0

76. El Paso 61 -38.8

77. Citigroup 2,719 1.7

78. Oracle 1,030 -52.7

79. Hartford Financial Services Group 2,486 2.1

80. Wells Fargo 5,945 6.8

81. Harrah’s Entertainment 526 -4.0

82. Ford Motor 27,358 -20.3

83. Gillette 1,584 -1.2

84. Avon Products 309 -4.6

85. AOL Time Warner 4,244 -8.6

86. Lehman Brothers Holdings (15,106) -2.5

87. Merrill Lynch 504 -61.3

88. Exelon 1,073 -2.1

89. Amgen 1,191 -27.1

90. Lucent Technologies (1,115) -58.6

91. Baxter International 987 -18.7

92. General Electric 23,645 4.2

93. AES 367 -27.4

94. National Semiconductor 530 8.7

95. Cisco Systems 3,489 -43.2

96. EMC 1,793 -15.0

97. Microsoft 6,497 -43.1

98. Intel 12,466 -2.8

99. Home Depot 2,751 -1.6

100. Schlumberger 1,505 -8.5

ADJUSTING CASH FLOW FROM OPERATIONS: DEFINITIONS

1. REPORTED OPERATING CASH FLOW. Cash provided by operating activities, including continuing and discontinued operations, as reported on the cash-flow statement.

2. ADJUSTED OPERATING CASH FLOW. Reported operating cash flow:

a. Plus operating cash flow used by discontinued operations

Minus operating cash flow provided by discontinued operations

b. Minus realized tax benefits from nonqualified stock options

c. Plus taxes paid on nonoperating gains

Minus taxes received on nonoperating losses

d. Plus decrease in securitized accounts receivable

Minus increase in securitized accounts receivable

e. Minus increase in accounts payable exceeding proportion increase in revenue

f. Plus aftertax cash payments for such nonrecurring items as restructuring costs, severance payments, merger costs, and litigation charges

Minus aftertax cash receipts for such nonrecurring items as litigation awards

g. Plus proceeds from sales of trading securities

Minus disbursements for purchases of trading securities

h. Plus decrease in cash overdrafts included in operating cash flow

Minus increase in cash overdrafts included in operating cash flow

i. Minus capitalized operating costs

Minus capitalized interest

3. % INCREASE/DECREASE DUE TO ADJUSTMENTS. The percentage increase or decrease between reported operating cash flow and adjusted operating cash flow.

Source: Charles Mulford, Georgia Institute of Technology

MORE OR LESS FREE

Comparing free cash flow with adjusted free cash flow for the S&P 100,

2000-2001: Top gainers and losers.

2001 2001 2001

Unadjusted Adjusted % Adjustment

Free Free Improved/

Company Cash Flow Cash Flow Worsened

TOP 10 GAINERS

1. HCA 43 947 2102.2

2. Unisys 3 56 1759.4

3. AT&T 575 5,539 863.3

4. DuPont 1,168 11,178 857.0

5. Raytheon (344) 583 269.4

6. International Paper 665 2,179 227.7

7. Alcoa 1,232 3,621 193.9

8. Sara Lee 1,018 2,904 185.3

9. Norfolk Southern 64 175 173.5

10. Xerox 1,402 3,347 138.7

TOP 10 LOSERS

1. Williams (102) (1,436) -1308.2

2. Clear Channel Communications 95 (887) -1035.8

3. Schlumberger (454) (5,122) -1028.2

4. Dow Chemical 355 (1,843) -619.3

5. Medtronic 1,204 (2,663) -321.2

6. AOL Time Warner 1,660 (2,491) -250.1

7. Baxter International 362 (538) -248.6

8. National Semiconductor (38) (113) -197.6

9. Intel 1,345 (1,177) -187.5

10. General Dynamics 843 (629) -174.6

2000 2000 2000

Unadjusted Adjusted % Adjusted

Free Free Improved/

Company Cash Flow Cash Flow Worsened

TOP 10 GAINERS

1. HCA 392 392 -0.1

2. Unisys 242 (8) -103.2

3. AT&T (298) (16,407) -5405.6

4. DuPont 3,838 3,182 -17.1

5. Raytheon 569 1,011 77.7

6. International Paper 1,078 (2,124) -297.0

7. Alcoa 1,728 (1,369) -179.2

8. Sara Lee 945 78 -91.7

9. Norfolk Southern 748 421 -43.7

10. Xerox (253) (904) -257.3

TOP 10 LOSERS

1. Williams (880) (1,626) -84.8

2. Clear Channel Communications 636 (783) -223.1

3. Schlumberger 471 (643) -236.6

4. Dow Chemical 49 (470) -1058.7

5. Medtronic 1,392 1,550 11.3

6. AOL Time Warner 1,070 (3,189) -398.0

7. Baxter International 566 (23) -104.1

8. National Semiconductor 248 152 -38.8

9. Intel 6,153 3,479 -43.5

10. General Dynamics 816 710 -13.0

ADJUSTING FREE CASH FLOW: DEFINITIONS

1. UNADJUSTED FREE CASH FLOW. Reported cash provided by operating activities minus capital expenditures net of dispositions minus preferred dividends.

2. ADJUSTED FREE CASH FLOW BEFORE ACQUISITIONS. Adjusted cash provided by operating activities minus capital expenditures net of dispositions minus preferred dividends. Adjustments to operating cash flow for restructuring and severance costs were removed for calculations of adjusted free cash flow.

3. NET CASH (PAID) RECEIVED IN ACQUISITIONS. Cash paid in acquisitions net of divestitures. Will constitute cash received when divestitures exceed acquisitions.

4. ADJUSTED FREE CASH FLOW AFTER ACQUISITIONS. Adjusted free cash flow before acquisitions minus cash paid in acquisitions net of divestitures.

5. % INCREASE/DECREASE DUE TO ADJUSTMENTS AND ACQUISITIONS. The percentage increase or decrease between unadjusted free cash flow and adjusted free cash flow after acquisitions.

Source: Charles Mulford, Georgia Institute of Technology

RELATED ARTICLE: FREE AT LAST?

THE ADJUSTMENTS to operating cash flow described in the main article naturally affect free cash flow, a measure widely used by analysts engaged in fundamental research. But free cash flow requires some adjustments of its own in the eyes of Georgia Tech accounting professor Charles Mulford. As a result, he undid certain adjustments he’d made for operating cash flow and undertook some additional ones (see table, page 52). In the process, he found that free cash flow for the S&P 100 averaged 1 percent less than it would have based on reported numbers last year, versus no change on average the year before.

Unfortunately, it’s not possible to compare Mulford’s analyses of free cash flow and operating cash flow in aggregate terms, because he excluded financial services firms from the free cash flow analysis. He chose to omit those companies, he explains, because too many extra adjustments would have been necessary to be confident of the findings.

Even on an individual basis, says Mulford, his free cash flow findings shouldn’t be relied on too heavily. One reason is that there is no Financial Accounting Standards Board standard for calculating free cash flow. The nonstandard but widely accepted practice seems simple enough at first glance: it calls for subtracting capital expenditures from operating cash flow. But while companies must report capital expenditures, the figures change dramatically from one period to another. What’s more, Mulford says it’s often difficult to tell whether what companies report for capital expenditures is before or after asset dispositions. As a result, he says, “operating cash flow is a better measure of what is sustainable.”

He also says that some of his adjustments to free cash flow are likely to be quite controversial. To arrive at adjusted numbers for free cash, for instance, he subtracts not only capital expenditures, but also restructuring charges and cash flow from acquisitions. He subtracts restructuring charges because they reduce cash available to investors. And he subtracts cash flow from acquisitions because they’re needed to grow rather than operate the business. The adjustments for acquisitions are likely to generate the most sparks, says Mulford, as many analysts contend that acquisitions have been fundamental to serial acquirers’ business.

Of course, whether acquisitions will happen as regularly in the future as they have in the past is another matter.

RONALD FINK (RONFINK@CFO.COM) Is A DEPUTY EDITOR AT CFO.

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