Our world tour of non-GAAP accounting metrics continues this week by looking at yet another disclosure virtually every large company makes that doesn’t actually exist in Generally Accepted Accounting Principles: free cash flow.
According to the technical definition, free cash flow is calculated as your operating cash flow minus capital expenditures. In other words, it’s the amount of cash that remains after the company pays to maintain its assets and operations. “FCF” is actually quite important to a business, since that is the cash that allows you to do other things—buy back shares, expand R&D, make acquisitions, and so forth. It is (or should be) the seed money for future growth, so the more free cash you generate, the more growth you can potentially achieve.
Here in the real world, free cash flow falls into a grey area of financial reporting. The number isn’t audited in the usual sense, where an external audit firm would examine it for accuracy and material error—but free cash flow is calculated from other numbers that are part of the annual audit. And certainly many people in investing circles believe that free cash flow sheds important light on a company’s financial performance.
That said, the SEC does have a few warnings about reporting free cash flow. It stresses that FCF “does not have a uniform definition and its title does not describe how it is calculated”—so if you want to report it, you need to describe how you calculate it and then reconcile the number back to GAAP-approved cash flows from operating activities. You also cannot report FCF on a per share basis since it’s a liquidity measure, and should refrain from hyping FCF as a pile of money available for any good idea that comes along; it might be needed to service debt covenants, for example.
We looked at the free cash flow reported by the S&P 500 for the last six quarters (although not all filers have submitted their second-quarter 2016 reports yet). Discarding the question of exactly how each company calculates free cash flow—and yes, we know, that question is a big one—on average, free cash flow is moving upward these days.
Average free cash flow per filer does fluctuate from one quarter to another, as you would expect. But overall, 2015’s numbers were higher than the comparable quarter in 2014, and 2016’s two quarters are higher than 2015’s.
Could those numbers be financial engineering intended to make Corporate America look better than it really is? Sure. Could it also be that to at least some extent, Corporate America actually is doing well these days? With all the other economic indicators suggesting that even if we’re not going like gangbusters, we are going in the right direction—well, you gotta wonder.
We’ll circle back with more in-depth analysis of free cash flow later this summer.
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