On the Importance of Free Cash Flow Metrics Bias Resulting from Static Approach to Free Cash Flow Analysis

Aleksandra Szpulak ()
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Aleksandra Szpulak: Wroclaw University of Economics

A chapter in The Essence and Measurement of Organizational Efficiency, 2016, pp 281-298 from Springer

Abstract: Abstract This paper discusses the accumulation of FCF for companies operating under different industry specific conditions resulting in a positive or negative difference between the length of the operating cycle and payables deferral period. On the basis of simulations on an easy spreadsheet financial model of company operations, it proves that: (1) in the case of a growing company operating under conditions of negative cash conversion cycle the FCF are systematically overestimated by a permanent increase in surplus cash generating from credit delivered by suppliers and employees and as such do not satisfy the definition of FCF, (2) indicates that FCF from operations suffer from timing and matching problems because they count accounting periods instead of operating cycles and therefore valuations based on such FCF are systematically overestimated every time the cash inflows from operating cycle occur earlier to the corresponding cash outflows and, reversely, are systematically underestimated every time the cash inflows from operating cycle occur later to the corresponding cash outflows. To overcome these problems, the on-going approach to free cash flows analysis that matches outflows and corresponding inflows is suggested. The application of a simple NPV to evaluate cash investments in the operating cycle (i.e. cash investments in operating working capital) based on net cash flows generated by operating cycle counts adequately for the industry specific differences in timing of operating cash flows and removes the relevant bias in FCF.

Keywords: Operating working capital; Operating cycle; Free cash flow from operations; Accrual accounting; Net present value (search for similar items in EconPapers)
Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:spr:prbchp:978-3-319-21139-8_17

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DOI: 10.1007/978-3-319-21139-8_17

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