Journal of Accounting and Finance Vol. 17(1) 2017 11
On the Definition, Measurement, and Use of the Free Cash Flow Concept in
Financial Reporting and Analysis: A Review and Recommendations
Shyam B. Bhandari, PhD
Bradley University
Mollie T. Adams, PhD, CPA
Bradley University
The concept of free cash flow was first proposed by Jensen (1986) in the context of the agency problem;
however he did not propose a specific calculation for free cash flow. Since then free cash flow has
become a popular metric for academic researchers and financial statement users, but there is much
variation in how free cash flow is being calculated. We highlight the variety of ways that free cash flow is
calculated, discuss the problems associated with having such a wide variation, and make
recommendations to address the issue.
INTRODUCTION
Cash flow is important to all individuals and organizations. For a business organization, the cash flow
statement (CFS) is one of the four major financial statements included in its annual report. Many cash
flow metrics are available and can be derived from this financial statement. A new cash flow term, called
free cash flow (FCF) was first coined by Jensen (1986) in the context of agency conflict. He defined FCF
as cash flow in excess of that required to fund all projects that have positive net present values when
discounted at the relevant cost of capital. According to Jensen Conflict of interest between stockholders
and managers over payment policies are especially severe when the organization generates substantial
free cash flow. He proposed the Free Cash Flow Theory of Takeovers and cited a few studies to
support his theory. He neither measured nor performed empirical analysis to support various FCF
hypotheses. Nevertheless the FCF concept has become very popular among financial statement preparers,
financial analysts, academics, and textbook authors. The purpose of this paper is to review and critique
the definitions, measurement, and use of the FCF concept in existing literature and in financial reporting.
The paper is organized as follows. First, we discuss the importance of cash flow in financial analysis
and business decision making. Second, we discuss the use of the FCF concept in financial research. Third,
various definitions of FCF in finance and accounting textbooks are described and the different measures
of FCF are calculated for a single firm. Fourth, the use and regulation of FCF in financial reporting is
described. The paper ends with conclusions and recommendations for a course of action needed for the
future use of this concept.
12 Journal of Accounting and Finance Vol. 17(1) 2017
IMPORTANCE OF CASH FLOW
Cash flow is a not only a popular term, but it is an important concept in the academic disciplines of
accounting, finance, and economics and in all business operations. Both the level of, and change in, cash
flow provide useful information in assessing a firms performance and its future direction. Net income as
reported on an income statement is the result of an accrual basis (not cash basis) accounting system. It is
probably the most popular number disclosed by all business entities. It is watched by analysts, investors,
media reporters and all stakeholders, but it is not cash! Accounting income can be used as information in
projecting future cash flows, but it is cash, not accounting income, that buys things, and pays for wages,
salaries, taxes, interest and dividends, services and debt. Inadequate cash can lead to default on
outstanding liabilities and ultimately bankruptcy. Cash flow models are used for valuation of securities,
properties, mergers, acquisitions, capital assets etc. Thus the popular phrase, Cash is King.
Operating cash flow or cash flow from operations (CFO) is the one of the three major cash flow
numbers in the statement of cash flows (SCF), and by far the most important of the three. The CFO
represents a business cash generating ability from its core activities. For example, Caterpillar Inc.s core
activity is manufacturing earth-moving machineries, not selling stocks and bonds or selling a subsidiary
business. In spite of the importance of the SCF, very few textbooks or publishers of industry averages
have ratios based on information available in the SCF in general or the CFO in particular. Bhandari
(2003) has discussed the importance of the SCF and listed a few textbooks and many journal articles
which suggested a number of the CFO-based ratios for analyzing and evaluating a firm. In a review paper
Bellovary et.al. (2007) found that out of 165 bankruptcy prediction studies none used FCF as a predictor
variable but 64 used the CFO.
The phrase free cash flow is an intuitively appealing concept to both laymen and analysts. The pre-
fix free makes FCF a very attractive and meaningful term for all the stakeholders in an organization
whether for-profit or non-profits. FCF can be perceived as funds distributable to shareholders or
spendable by managers or both. However, since Jensens (1986) definition of FCF has subjective
components, it allows analysts, researchers, and managers to use their discretion and personal biases in
calculating a firms FCF. Analysts choice of all projects that have positive net present value and cost
of capital can influence the measurement of FCF. Therefore, unless a standardized metric is agreed upon
by academics and professionals, FCF will be more suitable for intra-company analysis, discussion and
decision making rather than inter-company comparison. In spite of its limitations FCF is an interesting
concept. It provides useful information to all stakeholders. Many investment advisory services and
websites explain FCF and some business firms are voluntarily reporting FCF.
USE OF THE FCF CONCEPT IN FINANCIAL RESEARCH
Subsequent to Jensens (1986) paper, researchers have used the FCF concept in many different
contexts. FCF has been used to test theory in dividend policy (Agarwal and Jayaraman, 1994; Bowden
and Posch, 2011; Fuller and Blau, 2010), valuation (Awasthi et.al., 2013; Phillips, 2003; and Vogt and
Vu, 2000 and Shefrin, 2014), portfolio performance (Hackel, 1994; Krueger and Wrosland, 2013), wealth
effect (Lee, 1998), share repurchase (Vafeas and Jo,y 1995; Choi and Park, 1997), sales growth (Brush
et.al., 2000), international joint venture (Chen et.al., 2000), operating performance (Freund et.al., 2003),
straight debt issues (Howton et.al., 1998), advertising budget (Joseph and Richardson, 2002), golden
parachutes (Subramaniam and Daley, 2000), capital structure (Buus, 2015), stock prices (Decamp et.al.,
2011), bankruptcy (Dhumale, 1998), and audit fees (Griffin et.al., 2010) to name a few. Most of these
researchers used their own calculation of FCF.
Most of FCF related research can be divided into two groups. The first group involves research papers
which defined, measured and performed empirical analysis to support their hypothesis; however, these all
had their own unique FCF metrics. Space limitations do not allow us to list each of these metrics but a
few examples follow: Agrawal and Jayraman (1994), Vafeas and Joy (1995) and. Lee (1998) measured
FCF as operating income before depreciation, minus interest expense, taxes, and dividends (both common
Journal of Accounting and Finance Vol. 17(1) 2017 13
and preferred). Hackel et.al. (1994) used two definitions of FCF and discussed deficiencies in estimating
FCF. According to them FCF is net operating cash flow in excess of capital expenditure and a second,
that is equivalent to the first but adds back discretionary cash flows... Phillips (2003) used FCF as CFO
less the increase in plant and net working capital. Freund et.al. (2003) and Choi and Park (1997) both
measured FCF based on all income statement data and none from the SCF. Howton et.al. (1998) defined
FCF equal to operating income minus interest minus cash dividends minus net taxes.
The second group of researchers simply inserted FCF in the title of their paper but neither defined nor
measured FCF, much less used it in their empirical analysis. These remind us of the famous commercial,
where is the beef? For example see the papers of Bowden and Posch (2011), Decamps et.al. (2011), and
Fuller and Blau (2010). Bowden and Posch (2011) invoked the FCF concept as a constraint on managerial
bonuses and shareholder dividends without defining and calculating FCF or performing empirical
analysis. Decamps et.al. (2011) likewise indirectly connected FCF with undistributed profits, which
managers use to their advantage - an agency conflict scenario. Fuller and Blau (2010) referenced the FCF
problem in connection with high and low dividend payment policies. Their empirical model did not have
FCF as a test variable. Dhumale (1998) claimed validation of FCF theory without computing FCF much
less including it as one of the predictor variables in his bankruptcy prediction model. He tried twenty-one
ratios to construct the model. Four ratios had cash flow in the numerator but not a single ratio had FCF.
Kissan and Richardson (2002) used change in discretionary money and Subarmaniam and Daley (2000)
used net capital expenditure to asset ratio as a surrogate for FCF.
Awasthi et.al. (2013) investigated the relationship between different FCF metrics and the value of the
firm; the unique feature of their study is that they calculated a number of FCFs from publicly available
information. Krueger and Wrosland (2013) used FCF data from Morningstar, Inc. to construct a more
efficient portfolio. Stephen and Vu (2000) used Value Lines Large free Cash Flow Generator data to
test Jensens (1986) FCF hypothesis. Mills et.al. (2002) list twelve different definitions of FCF in use by
corporations, magazines, textbooks, and publishers of financial information. In the light of the discussion
above, it is obvious that there are just too many metrics of FCF being used to draw conclusions which
leads to the question of whether these conclusions would hold if an alternative metric was used.
DEFINITION AND CALCULATION OF FCF IN FINANCE AND ACCOUNTING TEXTBOOKS
Many textbook authors have defined and presented a formula for FCF. There is no unanimity among
them and when applied to the financial data of a company (Caterpillar Inc. as an example here, see
Appendix A for key financial statement data) we get different numbers.
Brigham and Houston (2016, p.75) define FCF as the amount of cash that could be withdrawn
without harming a firms ability to operate and to produce future cash flows. Their measurement formula
and calculation (in millions) of Caterpillars FCF for the year 2014 is:
FCF
Brigham
= [EBIT (1-Tax rate) + Depreciation] [Capital Expenditure +/- Net Operating (1)
Working Capital]
= [6,191 (1-.2715) + 2,795] [3,379 -662] = 4,588
It is important to note that there is also variation in the calculation of net operating working capital
(NOWC). Not all of the textbooks that include NOWC in their calculation of FCF specifically define how
they calculate NOWC. In all of our calculations we calculate NOWC as: (Cash + Accounts Receivable +
Inventories) (Accounts Payable + Accrued Expenses).
Ross et.al. (2013, p.32), while admitting that in practice there is some variation in exactly how free
cash flow is computed, prefer to use the term total cash flow or distributable cash flow rather than
FCF and measure it as operating cash flow, which they define as earnings before interest and depreciation
and less taxes, adjusted for capital spending and the change in net working capital. While they do not
provide a formula for their calculation, we have constructed the following formula based on their
explanation of the concept.
14 Journal of Accounting and Finance Vol. 17(1) 2017
FCF
Ross
= EBITDA (1-Tax Rate) Capital Expenditure +/- Net Working Capital (2)
= 9,354(1-.2715) 3,379 + 48 = 3,483
Cornett et.al. (2012, p.48) take the perspective that FCF is cash available for distribution to the
companys investors (including both creditors and stockholders) and define it as after-tax operating
profit minus the amount of new investment in working capital, fixed assets, and the development of new
product, i.e.
FCF
Cornett
= [EBIT (1-Tax rate) + Depr.] [ Gross fixed assets + Net operating working capital] (3)
= [6,191 (1-.2715) + 2,795] [256 -662] = 7,711
Brealey et.al. (2015, p.67) define FCF as cash available for distribution to investors after the firm
pays for new investments or additions to working capital. Their computation is simply cash flow from
operations minus capital expenditure; both numbers are available from the SCF. Schroeder et.al. (2014,
p.266) and Stice and Stice (2014, p.23-23) use the same formula as Brealey et.al. (2015). Schroeder et.al.
(2014) argue, however, that a more correct measure of FCF would be cash flow from operations less
capital expenditures necessary to maintain current growth, but recognize that we have to estimate it using
all capital expenditures since capital expenditures necessary to maintain current growth cant be found in
the financial statements. Stice and Stice (2014) measure FCF as cash flow from operations less capital
expenditures, and use discounted estimated future FCF to estimate the current value of the firm. FCF for
Caterpillar under this formula would be:
FCF
Brealey
= CFO Capital Expenditure (4)
= 10,191 3,379 = 6,812
Kieso et.al. (2013, p.234) define FCF as discretionary cash flow otherwise cash available for a
company to purchase additional investments, retire its debt, purchase treasure stock, or simply add to its
liquidity. They measure FCF as cash flow from operations less capital expenditures and dividends. This
calculation is also consistent with the Phillips et.al. (2016, p.550) description of FCF as cash flows from
operations over that which is needed for replacing existing property, plant, and equipment and to pay
dividends to stockholders. Phillips et.al. (2016) do not give a specific calculation for FCF. The Kieso
(2013) formula is as follows.
FCF
Kieso
= CFO Capital Expenditure Dividends (5)
= 10,191 - 3,397 1,620 = 5,192
Palepu and Healy (2013, p.5-26) calculate two different measures of FCF, one that is FCF to both
debt and equity holders (FCFDE) and one that is free cash flow to just equity holders (FCFE). Both of
their FCF measures can be calculated by starting with CFO from the cash flow statement. In the FCFDE,
CFO is first adjusted for after-tax net interest expense or income and then subtracting net cash flow used
for investing activities. In FCFE, the CFO is not adjusted for after-tax net interest expense or income, and
the net cash flow used for debt repayment and issuance as well as the net cash flow used for investing
activities is subtracted. The two formulas are as follows:
FCFDE
Palepu
= [CFO+/- (Net Interest Expense (1-T)] Net Cash Flow used for Investing Activities (6)
= [10,191 + 1,108(1-.2715)] 3,672 = 7,326
FCFE
Palepu
= CFO Net Cash Flow used for Investing Activities Net Cash Flow used for Debt
Repayment and Issuance (7)
= 10,191 3,672 + 2,444 = 8,963
Journal of Accounting and Finance Vol. 17(1) 2017 15
Its important to note that in 2014, Caterpillar had a net positive cash flow (cash from rather than cash
used for) from debt repayment and issuance, which is why the 2,444 is added rather than subtracted in the
above calculation.
The reader can see that FCF for Caterpillar Inc. for year 2014 can range from $3,483 to $8,963
depending on which viewpoint and textbook is followed. This calls for an urgent need for consensus
among academics and professionals to precisely define and measure FCF.
USE OF FCF IN FINANCIAL REPORTING
In 1987, the Financial Accounting Standards Board (FASB) released Statement of Financial
Accounting Standard No. 95 (SFAS 95) (1987) now codified under FASB Accounting Standards
Codification (ASC) 230-10. ASC 230-10 requires the issuance of a SCF and provides guidance on the
form and content of that statement. ASC 230-10 neither defines nor requires the disclosure of FCF.
Companies that fall under the jurisdiction of the US Securities and Exchange Commission (SEC) may
still report financial metrics, such as FCF, that are not defined by US Generally Accepted Accounting
Principles (US GAAP) as long as the disclosure of such measures are within the boundaries of SEC
regulation. The disclosure of FCF as a part of a companys financial reporting has gained popularity over
the last 25 years. Adhikari and Duru (2006) examine 10-K and 10-Q reports filed between 1994 and 2004
and document that the disclosure of FCF increased from 12 companies in 1994 to 176 companies in 2004
with 429 companies disclosing FCF at least once during the 10 year period. Unfortunately, because US
GAAP does not define a standard measure of FCF, there is variance in the FCF measures that are
disclosed.
Two viewpoints of FCF are discussed in the context of financial reporting: the capital maintenance
viewpoint, where FCF represents the amount of cash that management can spend without reducing the
productive capacity of the business, and the all-inclusive viewpoint, where FCF represents the amount of
cash available to be spent at managements discretion (Adhikari and Duru, 2006; Mills et.al., 2002).
While it appears that the capital maintenance viewpoint is the viewpoint most widely accepted by US
regulators (SEC 2016), international standard-setters (IASB, 2014a; IASB, 2014b), and financial
statement preparers (Adhikari and Duru, 2006; Mills et.al., 2002), there is variation in how FCF under the
capital maintenance viewpoint is calculated and some companies still report FCF under the all-inclusive
viewpoint. Ahikari and Duru (2006) subdivide their sample based on the starting point of the calculation
of FCF. 55.6% of their sample used CFO as reported in the SCF as the starting point for FCF. Of those,
72.6% took a capital maintenance perspective and calculated FCF using one of the following four
formulas:
FCF = CFO capital expenditures (consistent with Brealy, 2006) (8)
FCF = CFO capital expenditures net working capital (consistent with Ross et.al. 2013) (9)
FCF = CFO nonrecurring charges maintenance based capital expenditures (10)
FCF = CFO investing activity (11)
The other 27.4% took an all-inclusive viewpoint and calculated FCF using one of the following three
formulas:
FCF = CFO capital expenditures debt payment (12)
FCF = CFO capital expenditures dividend (consistent with Kieso et.al. 2013) (13)
FCF = CFO investing activity dividend (14)
Ahikari and Duru (2006) also document that 14.2% of their sample calculate FCF using a starting
point of either EBITDA or Net Income (which they do not subdivide by viewpoint) and 30.2% use some
other type of calculation that could not be easily categorized. Mills et.al. (2002) provides two examples of
16 Journal of Accounting and Finance Vol. 17(1) 2017
companies that calculate FCF under the capital maintenance viewpoint, but using calculations that are
unique to those documented by Adhikari and Duru (2006) as follows:
FCF = CFO business investments where business investments are selected investing activities (15)
FCF = Income from Operations + pre-opening expenses + abandonment loss + depreciation +
amortization + interest + dividends + other income cash taxes paid + proceeds from disposal of
equipment and other assets (16)
In recent years the SEC has expressed concern and has increased regulation over the disclosure of
non-GAAP measures in general, and the disclosure of FCF specifically. The SEC, under Regulation S-K,
requires that any non-GAAP measure included in an SEC filing must be reconciled to the most directly
comparable GAAP measure (SEC, 1933). In the case of FCF, this would be CFO. In 2003, they passed
Regulation G which requires the same reconciliation for all non-GAAP measures included in voluntary
earnings disclosures (SEC, 2003). In May 2016, the SEC updated the Compliance and Disclosure
Interpretations on the use of non-GAAP measures in SEC filings (SEC, 2016). In the updates, the SEC
specifically allowed the disclosure of FCF; however, they expressed concern over the fact that there is not
a uniform definition for FCF and that its title is not descriptive of how the measure is calculated. To
address these concerns, they required a description of how the measure is calculated in addition to the
required reconciliation to GAAP cash flows. The SEC assumed a capital maintenance viewpoint of FCF
and indicated that they would consider it misleading for a company to represent FCF as a measure of cash
available for discretionary spending when it often does not take into account debt service or other non-
discretionary expenditures. Finally, the SEC disallowed the presentation of FCF on a per share basis as
they view it as a measure of liquidity rather than a performance measure.
While the use of FCF is on the radar of accounting standard setters, they have yet to define or
incorporate FCF in their financial reporting requirements. The International Accounting Standards Board
(IASB), who writes the International Financial Reporting Standards (IFRS) used by much of the world,
have both encouraged (but not required) companies to disclose separately cash flows that increase
operating capacity and cash flows required to maintain current operating capacity (IASB, 2014a) so that a
measure of FCF can be calculated and expressed concern that the distinction between cash flows that
increase and cash flows that maintain operating activities would be arbitrary (IASB, 2014b). The FASB
has been silent on the issue of FCF specifically; however, FASB Chairman Russell Golden indicated in an
April 2016 video that they anticipate issuing an agenda consultation paper to discuss potential
improvements to or new types of financial metrics for the SCF (Davine et.al. 2016).
CONCLUSION AND RECOMMENDATIONS
Jensen (1986) introduced the idea of FCF in the context of agency theory. He hypothesized that FCF,
if not paid out to shareholders, encourages managers to invest in unprofitable projects. Since then
academics have used a variety of metrics of FCF to investigate a variety of financial issues. Due to the
fact that FCF is not defined as an accounting concept under US GAAP, the FCF metrics used will be at
the discretion of academic researchers, financial statement users, financial statement preparers, and
textbook publishers. The conclusions drawn using these measures will be biased, difficult to interpret and
may not hold under an alternative measure of FCF. While discretionary FCF measures may be useful in
intra-firm analysis and decision making purposes, for inter-firm analysis a standardized FCF metric is
imperative. We suggest the following guidelines to develop a standardized FCF metric:
1. It must be simple
2. It should be based on information derived from the SCF
3. It should start with the CFO
4. It should follow the all-inclusive viewpoint and adjust CFO for capital expenditures and
contractual cash obligations unaccounted for (e.g. taxes, debt service, preferred dividends)
5. The focus should be stockholders
Journal of Accounting and Finance Vol. 17(1) 2017 17
6. It should be supported by the FASB and included in US GAAP.
Until a consensus is developed, we recommend the following calculation of FCF:
FCF = CFO Capital Expenditures Debt Payments (17)
In our opinion FCF is supposed to be free cash available for distribution to stockholders after
capital expenditures needed to sustain current operations (not growth) and other non-discretionary cash
flow needs are met. Managements wasteful use of this free cash in unprofitable projects is consistent
with the agency problem propounded by Jensen (1986). We believe that the above formula is in the spirit
of the original FCF measure proposed by Jensen (1986). While the suggested calculation does not
distinguish between maintenance capital expenditures and growth capital expenditures or include cash
paid for preferred dividends, it is simple and all numbers can be obtained from the SCF. Since the SCF
contains information using a standard measurement as prescribed by US GAAP, a FCF measure derived
from the SCF will be more reliable for inter-firm analysis than discretionary FCF measures.
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Investment Survey. Journal of Managerial Issues, 12, (2), 188-207.
APPENDIX A
TABLE 1
KEY FINANCIAL STATEMENT DATA OF CATERPILLAR, INC.
(Dollars in millions)
Year 2014 2013
Total sales and revenues 55,184 55,656
Total interest expense 1,108 1,192
Operating profit (EBIT) 6,191 7,273
Income taxes 1,380 1,319
Profit (Net Income) 3,695 3,789
Cash 7,341 6,081
Receivables trade and other 7,737 8,413
Inventories 12,205 12,625
Current assets 38.867 38,335
Accounts Payable 6,515 6,560
Accrued Expenses (including wages) 5,986 5,115
Current liabilities 27,877 27297
Gross Property, Plant, and Equipment 31,572 31,316
Cash flow from operating activities (CFO) 8,057 10.191
Depreciation and amortization 3,163 3,087
Depreciation (per financial statement
footnotes)
2,795 2,710
Cash flow from investment activities (CFI) (3,627) (5,046)
Capital expenditure (1,539) (2.522)
Expenditures for equipment leased (1,840) (1.924)
Other CFI items - net (248) (600)
Cash flow from financing activities (CFF) (2,996) (4,511)
Dividends (1.620) (1,111)
Debt Payments (9,248) (10,870)
Debt Issuance 11,692 9,259
MAILING INFORMATION
Shyam B. Bhandari, PhD (Primary Contact)
Bradley University
Professor of Finance Emeritus
1501 W Bradley Ave
Peoria, IL 61625
309-677-2269
