2015 Proceedings of the Academy of Finance
Operating Cash Flows versus Free Cash Flows: An Assessment of Their Usefulness in
Shyam B. Bhandari*
The purpose of the proposed paper is to define, measure, and critically evaluate the usefulness
of two cash flow measures which are widely used in financial literature. These measures are cash
flow from operations (CFO) and free cash flow (FCF). The CFO is clearly defined, meticulously
measured and universally disclosed as mandated by generally accepted accounting principles
(US GAAP). Free cash flow has become a widely quoted term in finance literature over the last
thirty years. However, neither the definition of nor measurement of FCF is uniformly used by
finance academics and analysts. FCS is also not required by US GAAP. This paper will discuss
various definitions and the use and misuse of the FCF in financial literature.
CASH FLOW Cash flow is a not only a popular term but it is a important concept in academic
disciplines of accounting, finance, economics and all business operations. Both the level of and
change in cash flow provide useful information in assessing a firm’s performance and its future
direction. Net income (NI) as reported on an income statement is the result of an accrual basis
(not cash basis) accounting system. It is probably the most popular number disclosed by all
business entities. It is watched by analysts, investors, media reporters and all stakeholders, but it
is not cash! Cash, not accounting income, is what buys things; pays wages, salaries, taxes and
dividends and services and pays debt! Inadequate cash can lead to default on outstanding
liabilities and ultimately bankruptcy. Thus the popular phrase, “Cash is King.”
OPERATING CASH FLOW Operating cash flow or cash flow from operations (CFO) is the
one of the three major cash flow activities in the statement of cash flows (SCF); and by far the
most important of the three. The OCF represents a business’ cash generating ability from its core
activities. For example, Caterpillar Company’s core activity is manufacturing earth-moving
machineries; not selling stocks and bonds or selling a subsidiary business. An analyst ought to be
concerned more about CFO rather than NI of Caterpillar Company. In spite of that, very few
textbooks and publishers of industry averages have ratios based on information available in the
SCF. Bhandari (2003) has discussed importance of statement of cash flow (SCF) and suggested
a number of CFO based ratios for analyzing and evaluating a firm.
FREE CASH FLOW Another cash flow measure known as free cash flow (FCF) was first
coined by Jensen (1986) in his AER paper. He defined FCF as “cash flow in excess of that
required to fund all projects that have positive net present values when discounted at the relevant
cost of capital.” In this paper he neither measured nor performed empirical analysis to support
various FCF hypotheses. Since then hundreds of papers have been published most of which
simply quoted the term FCF. Some defined FCF but did not measure. A few did measure FCF
and perform empirical tests using FCF. Many papers simply quoted the term, nothing else.
Although FCF is a very interesting concept, it has been used, misused and abused by researchers
and managers. This is because Jensen’s definition is subjective which has allowed analysts,
researchers, and managers to use their discretion to define and measure FCF to suit their purpose.
Shyam B. Bhandari*, Professor of Finance, Foster College of Business, Bradley University,
(309) 677-2269; firstname.lastname@example.org.
2015 Proceedings of the academy of Finance
LITERATURE REVIEW Subsequent to Jensen’s (1986) paper, researchers, analysts and
textbook authors have defined, measured and used FCF in different contexts. For example Lee
(1998) defined FCF as the discretionary cash flow in excess of that needed to fund all positive
net present value (NPV) projects. Brigham et al (2002) defined it as cash flow actually available
for distribution to investors after the company has made all investments in fixed assets and
working capital necessary to sustain ongoing operations. Agrawal and Jayraman (1994), Vafeas
and Joy (1995) and Lee (1998) measured FCF as operating income before depreciation, minus
interest expense, taxes, and dividends (both common and preferred). Hackel et al (1994) in their
study used two definitions of FCF and discussed deficiencies in estimation of FCF. According to
them “FCF is net operating cash flow in excess of capital expenditure, and a second that is
equivalent to the first but add back discretionary cash flows. In both cases, we excluded
nonrecurring cash flows”
Questionable use of FCF concept: A few recent studies invoked FCF in the title of their
research paper but neither defined nor measured FCF much less used it in their empirical
analysis. For example see highly theoretical papers of Bowden and Posch (2011), Decamps et al
(2011), and Fuller and Blau (2010). Griffin et al (2010, 328) in their paper did define FCF, but
measured it in their unique way to test the FCF hypothesis from an auditing perspective. Space
limitation will not allow us to cite numerous examples of researchers invoking FCF term in their
scholarly papers, but doing little to clearly define, measure, and perform explicit empirical
verification of the FCF hypothesis put forward by Jensen (1986).
A number of financial ratios are based on net income (NI), operating cash flow (CFO) and
other items available in financial statements. These ratios are used in financial analysis of firms
by academics, professional analysts and managers. Interestingly, in a review paper by Bellovary
et al (2007), out of 165 bankruptcy prediction studies none used FCF as a predictor variable; 64
used CFO and 54 used net income (NI).
FCF and FASB: The fact that FCF is not mentioned as an accounting concept in FASB’s
Standard No. 95 (1987) (now codified under FASB Accounting Standards Codification 230-10),
its use, misuse and abuse will continue unabated. This proliferation in use FCF without its
precise definition and widespread discretionary measurement has resulted in misuse and abuse of
a very interesting concept. It has undermined the perceived importance and usefulness of
information available in the CFS. Since CFS contains information in a standard format consistent
as prescribed by US GAAP, the cash flow measures derived from CFS are more reliable than
discretionary FCF measures. While, discretionary FCF measures may be useful in specific
situations or analyses, its misuse is a matter of concern to many academics.
An expanded version of this paper will further look into the use, misuse and abuse of FCF
concept in financial literature. We will suggest a measure of FCF based on data available in
audited US GAAP basis financial statements.
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2015 Proceedings of the Academy of Finance
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