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Excess Cash Margin, ECM, calculated by dividing by revenue the difference between adjusted operating cash flow and adjusted operating earnings, provides useful insight into the relationship between cash flow and earnings. When ECM declines in a consistent manner it indicates that earnings are growing faster or declining more slowly than cash flow. As a result, relative to the scale of operations, increasing levels of non-cash accounts are accumulating on the balance sheet. Earnings generated in this manner, that is, with declining cash flow confirmation, are not sustainable and are at risk for decline. When ECM increases consistently it indicates that operating cash flow is either growing faster or falling more slowly than earnings. As a result, relative to the scale of operations, the balance sheet is being liquidated. Operating cash flow generated in this manner, that is, without consistent earnings support, is not sustainable and is at risk for decline. The better, more sustainable relationship between operating cash flow and earnings is when the two measures grow at consistent rates, resulting in a constant ECM through time.

This study calculates ECM for the non-financial firms of the S&P 100 for the years 2000, 2001, 2002, and 2003 and provides commentary on the results. Insights are provided into firms with a declining ECM, an increasing ECM and a stable ECM.


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Items of property, plant and equipment are often acquired through non-cash investing and financing activities. In these transactions, equipment-purchase financing is provided at the time of purchase. While such transactions increase a company's productive capacity, they are not reported as capital expenditures in the statement of cash flows. Accordingly, free cash flow calculated based on capital expenditures reported in the statement of cash flows will often be overstated when assets are acquired through such non-cash transactions. In this report we look at a series of non-cash investing and financing transactions and assess their effects on calculated free cash flow.


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In a sale and leaseback transaction an asset is sold and simultaneously leased back. As a result, the seller/lessee relinquishes ownership but not possession of the asset in question, which can be most any long-lived asset, including real estate or equipment. Some firms have even sold and leased back rights to motion picture films.

While there is general agreement on the reporting treatment for sales entailing leasebacks that are capital leases, reporting practices differ for sales proceeds when the underlying leasebacks are accounted for as operating leases. Some companies include sale proceeds in the investing section of the statement of cash flows, while others report them as financing cash flow. As a result, calculations of free cash flow that use net capital expenditures, or gross capital expenditures net of the proceeds from asset dispositions, may not be comparable across firms. In this study, we examine and highlight cashflow reporting practices for proceeds from sale and leasebacks for a broad cross-section of firms from various industries.


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Operating cash flow in 2000, 2001, 2002 and 2003 for the S&P 100 was adjusted to remove items that may provide misleading signals of operating performance. Ten adjustments were made, separated into three categories - (1) where flexibility in GAAP for cash flow reporting was used to alter cash flow, (2) where the requirements of GAAP result in misleading operating cash flow amounts, and (3) where nonrecurring operating cash receipts and payments lead to operating cash flow that is non-sustainable. Adjustments resulted in an average company change in operating cash flow in 2001 of 1.5%, in 2002 of 4.2%, and in 2003 of 0.7%. Certain individual company adjustments were quite significant, resulting in some cases, in much more operating cash flow than actually reported, and in other cases, much less. Many companies had an increase or decrease in operating cash flow of greater than 10% including 35 in 2001, 26 in 2002, and 22 in 2003.

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Note: These files were originally posted on October 8 and have been revised as of October 26 to include some technical adjustments as well as the restated financial statements of El Paso Corporation, which were released to the public in October 2004.


As instances of alleged cases of accounting fraud and earnings management have increased in recent years there has been a "discovery" of sorts of free cash flow by investors, analysts and the financial press. Such a development is interesting because certainly free cash flow is not new. It has always been of primary importance to investors for purposes of valuation.

References to the metric have grown markedly in recent years and it is now being used in new and varied ways. One such use is in the calculation of incentive compensation.

This report provides evidence of the recent increase in interest in free cash flow and surveys its use in incentive compensation agreements.

Portions of this report were adapted from the upcoming book, "Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance," by C. Mulford and E. Comiskey, scheduled for publication later this year by John Wiley & Sons.

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A sale made on open account boosts net income but does not provide operating cash flow until the related amount due from the customer has been collected. Accordingly, in computing operating cash flow, subtractions must be made from net income for increases in accounts receivable.

While there is general agreement on the reporting treatment for changes in accounts receivable in the computation of operating cash flow, reporting practices differ when customers are offered more formal repayment arrangements, for example, in the form of notes receivable. Some companies include such customer-related receivables in the computation of operating cash flow, while others report them in the investing section. Reporting such receivables as investing cash flow results in higher operating cash flow when the balance of such receivables is rising. As a result, the potential exists for a misimpression of a company's operating performance. In this study we highlight cash-flow reporting practices for such customer-related receivables.


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An important measure of financial performance is a firm's ability to generate sustainable, discretionary cash flow from operations. Many analysts and investors consider free cash flow to be a useful gauge of such performance. Reporting firms are all too happy to report their performance on a free cash flow basis. Disclosures of free cash flow are common and growing.

Because free cash flow is not defined by GAAP, definitions differ across firms. Accordingly, there is a lack of comparability across firms that opens an opportunity for confusion in assessments of financial performance.

This report surveys the reporting practices and definitions of free cash flow employed by a wide selection of firms. The objective is to catalog the various measures of free cash flow that are being employed and to determine the extent to which these measures differ from what is referred to as a benchmark measure of free cash flow: operating cash flow less net capital expenditures and preferred dividends.


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With the Dow Jones Industrial Average once again trading above 10,000, investors understandably are wondering where the blue chips are headed next. An interesting long-term perspective on the subject can be gained by examining the extent to which Nominal Gross Domestic Product has explained the movement of share prices over time.


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An Effective Antidote to Hedge Accounting

Natural hedges offer a low-cost and often no-cost alternative to the costs and restatement risks associated with hedge accounting.  In this report we look at the use of natural hedges to reduce the balance sheet risk and earnings volatility associated with foreign currency exposure. Our objective is to clarify terminology and identify how natural hedges are being used in practice.

Using a sample of disclosures from 70 companies we find that many firms are using pure natural hedges, a simple by-product of a firm’s operations, to address foreign currency risk.  However, derivatives that are not designated as accounting hedges, referred to here as quasi-natural hedges, are also frequently used.  Often, especially for large multinationals, a consolidated or entity-wide approach is used in offsetting foreign currency risk.  In evaluating how hedges are being used in practice we noted that a majority of firms are using natural or quasi-natural hedges to offset foreign currency revenues and expenses, foreign currency assets and liabilities or foreign currency receivables and payables.

With the results provided in this report, financial managers and CFOs as well as outside investors will gain insight into how firms are using natural hedges to limit earnings volatility while avoiding the costs and risks associated with hedge accounting.   Also, evidence on how firms are using natural hedges to reduce the need for hedge accounting should provide helpful input to the FASB.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


Download this report


Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


Download this report


Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Cash Flow Trends and Their Fundamental Drivers:Comprehensive Review (Quarter 1, 2012)

FREE CASH MARGIN INDEX: