Go with the (free cash) flow

A look at one of the most important financial gauges you've never heard of

BY JUNU KIM

Many armchair financial analysts gauge a public company's performance by revenues, earnings and earnings per share. However, for real insights into a company's performance and financial strength many analysts and investors turn to the cash flow statement. In particular, investors are interested in how much cash the company has available to utilize for its growth strategies. A number of companies, including Boeing, use a measurement called free cash flow to most directly identify available cash.*

Free cash flow represents the amount of money a company generates from its operations after investing for the future in property, plant and equipment. Growth in free cash flow often comes from higher sales, but important keys to consistently strong free cash flow across the enterprise are higher profits, reduced assets and enhanced efficiency.

''Generating cash from operating activities is an important measure of performance,'' said Barbara Lougee, an assistant professor of accounting at the Graduate School of Management at the University of California, Irvine.

The ability to generate free cash flow has been a strength of The Boeing Company. It is especially evident in the current economic downturn. Boeing's free cash flow was up 25 percent to $3.4 billion in 2002 despite a 7 percent decrease in revenue from 2001. ''Our cash flow was at the top end of our expectations, highlighting our overall operating and financial strength,'' said Boeing Chairman and CEO Phil Condit in a Jan. 30 teleconference in which Boeing reported its 2002 financial results.

To understand cash flow, it is important to recognize that earnings include a number of ''non-cash'' expenses that do not reflect the cash generated by a company in any given period. The differences between cash flow and earnings include ''non-cash'' items such as depreciation, amortization, share base compensation expense and cumulative effects of accounting changes. Depreciation expense can be significant for manufacturing companies such as Boeing that are capital intensive. Free cash flow also takes into consideration the result of running your operations more efficiently, reflecting efforts to reduce the investment in assets such as inventories and property, plant and equipment.

William Henry, managing director at Reese McMahon LLC, a Chicago-based business consultancy, compares free cash flow to the ''cigar-box accounting'' method that storekeepers in past generations might have conducted. Mom-and-pop proprietors might have kept their cash in a cigar box or some other container. At the beginning of a business day, the box contained a certain amount of money. During the day, the storekeepers would add money to the box from selling products and take money out to pay their suppliers. The difference between how much money is in the cigar box at the beginning and the end of the day roughly represents free cash flow.

''In a sense, [free cash flow] lines up with cigar-box accounting: How much cash did I add to the cigar box in the quarter or the year in question?'' Henry said.

Obviously, companies strive to increase their free cash flow over time. However, looking solely at the free-cash-flow number doesn't totally reflect a company's fortunes. Some companies, especially younger firms, may report negative cash flow because they need to invest heavily to build their business. And other firms might show growing free cash flow because they've cut their capital expenditures or other investments in the business. In the latter instance, the question to ask is whether the cuts today will need to be reversed in the future to maintain or enhance productivity.

The lesson here: If you want a general snapshot of how a company's fared financially, look at a handful of measurements—and not merely earnings per share, the figure usually cited by business reporters. In addition to revenue and earnings, free cash flow helps complete the snapshot of a company's true financial picture.

''You should never look at one metric. You should look at several combined, to get a more complete picture,'' Lougee said.

junu.kim@boeing.com

* Free cash flow is a non-GAAP (generally accepted accounting principles) measure that equals net cash provided by operating activities less net additions of property, plant and equipment. Other companies using the term may calculate free cash flow differently.