Financial Accounting: An Integrated Statements Approach, 2nd Edition

Cash flow from operating activities

Less: Investments in fixed assets to maintain current production

Less:Dividends

Free cash flow

Analysts often use free cash flow, rather than cash flows from operating activities,

to measure the financial strength of a business. Many capital-intensive firms must ag-

gressively reinvest to remain competitive. This can reduce free cash flow. For exam-

ple,Motorola’s free cash flow is less than 10% of its cash flow from operating activities.

In contrast, Coca-Cola’s free cash flow is approximately 75% of its cash flow from

operating activities.

To illustrate, the cash flow from operating activities for Dell Inc.was $3,670 mil-

lion in a recent fiscal year. The statement of cash flows indicated that the cash

invested in property, plant, and equipment was $329 million and no dividends

were paid. Assuming that the amount invested in property, plant, and equipment

maintained existing operations, free cash flow would be calculated as follows (in

millions):

Cash flow from operating activities $3,670

Less: Investments in fixed assets to maintain current production 329

Less:Dividends

Free cash flow $3,341

During this period, Dell generated free cash flow in excess of $3 billion, which was

91% of cash flows from operations and over 8% of sales. The free cash flows for sev-

eral companies in the computer industry are shown for comparison purposes below

(in millions).

598 Chapter 13 Statement of Cash Flows

Apple Dell Hewlett- Sun

Computer Inc. Gateway Packard Microsystems

Cash flow from operating activities $934 $3,670 $73 $6,057 $2,226

Cash used to purchase property, plant,

and equipment (176) (329) (73) (1,995) (249)

Cash used to pay dividends (9) (977) —

Free cash flow $758 $3,341 $ (9) $3,085 $1,977

Free cash flow as a percent of cash flow

from operations 81% 91% 12% 51% 89%

Free cash flow as a percent of sales 9% 8% 0% 4% 18%

Positive free cash flow is considered favorable. A company that has free cash flow

is able to fund internal growth, retire debt, and enjoy financial flexibility. A com-

pany with no free cash flow is unable to maintain current productive capacity or

dividend payments to stockholders. Lack of free cash flows can be an early indica-

tor of liquidity problems. Thus, Gateway’s negative free cash flow would be a

concern to management and investors. As stated by one analyst, “Free cash flow gives

the company firepower to reduce debt and ultimately generate consistent, actual

income.”^4

4 Jill Krutick, Fortune, March 30, 1998, p. 106.