Cash america

CHEER UP, CORPORATE AMERICA. YOU'RE IN BETTER SHAPE THAN YOU LOOK.

That conclusion stems from a recent analysis of operating cash flow for the large-cap, blue-chip companies that make up the Standard & Poor's 100 Stock Index. The analysis was prepared for CFO by Charles W. Mulford, an accounting professor in the DuPree College of Management at the Georgia Institute of Technology, with the help of Michael Ely, an analyst in DuPree's financial analysis lab. It shows that after adjusting for nonrecurring and nonoperating items, operating cash flow for the S&P 100 in 2001 was an average of almost 9 percent higher than reported. That represents a distinct turnaround from the average downward revision of 4 percent that Mulford made to operating cash flow reported in 2000.

To be sure, adjusted operating cash flow for companies at or near the median point of the findings--such as Johnson & Johnson, H.J. Heinz, Black & Decker, The Southern Co., Campbell Soup, and Colgate-Palmolive--was virtually the same as reported both this year and last. But given investors' skepticism about the integrity of corporate reporting, the fact that more companies' cash flows weren't subject to downward revision is reason enough for optimism about the larger picture.

Mulford himself says so, though cautiously. After analyzing the financial statements of each member of the S&P 100 for the past two years to get a clearer picture of their operating cash flow, he says, "I was a little surprised at how many companies looked better, especially in 2001." Adds Mulford, a co-author of the recently published book The Financial Numbers Game: Detecting Creative Accounting Practices, "Maybe things aren't as bad as we thought."

Why focus on operating cash flow when most investors remain fixated on earnings? All things being equal, cash flow presents a clearer picture of a company's actual performance, simply because it reflects money received and paid out during a given interval, whereas earnings are based on all manner of estimates and assumptions. What's more, a growing number of companies have been directing investors' attention toward cash flow from operations, even as more than a few have misreported those results.

ADJUSTING THE FLOW

But the need to adjust what companies report as cash flow from operations arises even when they adhere to U.S. generally accepted accounting principles. For one thing, they often draw attention to pro forma numbers in press releases, including and excluding certain items as they see fit. That's no problem in the eyes of the Securities and Exchange Commission, as long as they also provide GAAP numbers and show how pro forma and GAAP performance can be reconciled.

Even under GAAP, though, exactly which activities should be considered part of operating cash flow is often subject to interpretation, and the result is a range of practices. Technology companies such as Cisco Systems Inc. and Lucent Technologies Inc. have long included tax benefits from stock options in operating cash flow, while Microsoft Corp., at least until recently, included them in cash flow from financing. Reporting practices vary in the same way, and for a much wider universe of companies, when it comes to cash flow generated by the securitization of receivables (see "We Can Work It Out: The 2002 Working Capital Survey," August). Yet with corporate scandals drawing so much public attention, any disconnect between accounting practices and economic reality quickly undermines investor confidence.

Then why not cut right to free cash flow, widely considered the purest measure of what's left at the end of the day for lenders (when calculated before interest) and for shareholders (after interest)? In fact, investors are now focusing more closely on this yardstick. While Unisys Corp., for example, uses cash flow from operations as one of its four primary compensation benchmarks for senior management, the company has found investors asking more and more questions about free cash flow--which Unisys is not quite currently producing, despite its recent turnaround efforts and strong operating cash flow after adjustment by Mulford. "We still have a ways to go," admits CFO Janet Brutschea Haugen.

The short answer is that the Financial Accounting Standards Board has come up with no standard means of reporting free cash flow, so efforts to adjust it for nonrecurring items are something of a shot in the dark (see "Free at Last?" facing page). At a minimum, then, Mulford's approach seems the most logical starting point for a close look at cash flow.

Granted, FASB has taken some steps to further standardize reporting of cash flow, but Mulford's adjustments suggest that in some cases the movement has been in the wrong direction. The board's Emerging Issues Task Force (EITF), for instance, recently decided that tax benefits from stock options should indeed be reported as cash flow from operations instead of financing activities (which explains Microsoft's change of heart). But Mulford, among others, disagrees with the EITE's thinking here, and subtracts these benefits when adjusting operating cash flow.

Adjustments for stock options and receivables securitization are just the beginning of his rethink (see chart, page 49). While generally accepted principles require proceeds from dispositions, for example, to be included in cash flow from investing activities, GAAP requires the tax payments and benefits that arise from those transactions to be included in cash flow from operations. However, since the activities that produced those items aren't ongoing, Mulford subtracts such tax benefits from operating cash flow and adds back the tax payments. He also subtracts increases in outstanding payables to the extent they exceed revenue growth by 25 percentage points or more. On the other hand, he adds back expenses such as severance payments related to restructuring and tax payments on gains on discontinued operations.

Some of these changes seem counterintuitive, insofar as expenses reduce cash and gains increase it. But again, when cash collections or payments are nonrecurring or nonoperating, Mulford excludes them, no matter what GAAP has to say about them. HCA Inc.'s case is noteworthy here. Last year, the hospital chain paid the government $900 million, including interest, to settle charges of Medicare billing fraud. That's obviously a considerable expense, and one that GAAP says should be included as a reduction in operating cash flow. But if anything qualifies as nonrecurring, this item should. Accordingly, Mulford added $648 million, the aftertax amount of the settlement, back to HCA's reported operating cash flow in 2001, which accounted for most of the company's 46 percent upward adjustment that year.

RUNNING THE GAMUT

Of course, the effects of Mulford's adjustments vary widely. The totals for individual companies in 2001 ranged from an upward revision of 509 percent for defense contractor Raytheon Co. to a downward adjustment of 22 percent for technology services provider Schlumberger Ltd. Interestingly enough, several of the 10 companies with the biggest upward adjustments--including J.P. Morgan Chase, Xerox, and Bristol-Myers Squibb, as well as Raytheon and HCA--have labored under a cloud of investor skepticism. Mulford's findings suggest that the skepticism may be unwarranted, or at least overdone.

In Raytheon's case, adjusted cash flow from operations was much better than reported last year, largely because of divestitures, including that in 2000 of its engineering and construction unit, a money-losing business that Wall Street had long been calling on the company to exit. Sure enough, the business produced most of the $635 million in operating cash flow that Mulford added back in 2001 for discontinued operations, helping raise Raytheon's total operating cash flow from a reported $133 million to $810 million. That, to be sure, was about 30 percent less than the $1 billion that Mulford figures was Raytheon's adjusted operating cash flow for 2000, but represented nowhere near as precipitous a decline as that based on reported numbers.

WORKING THE CAPITAL

Why would the effect be felt the year after the sale? The buyer later went bankrupt, leaving Raytheon with continuing liabilities. But those are soon coming to an end, says Franklyn Caine, CFO of Raytheon. In fact, Caine estimates that Raytheon's cash flow from continuing operations this year will soon be much closer to its total, and that it will be sustainable, thanks to more-efficient working capital management. While further improvements in working capital may not be forthcoming, he contends that maintaining the current level will help much more cash fall to the bottom line. "Getting working capital right goes along way toward sustaining growth," he says.