Adjusted average cash flow: Meaning, Criticisms & Real-World Uses

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- Financial Accounting Standards Board
- cash flow statement
- net income
- depreciation
- amortization
- working capital
- capital expenditures
- liquidity
- financial health
- operating activities
- investing activities
- financing activities
- Generally Accepted Accounting Principles
- non-GAAP financial measures
- balance sheet
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What Is Adjusted Average Cash Flow?

Adjusted Average Cash Flow refers to a modified version of a company's cash flow, typically from its operations, that has been altered to provide a more specific or comparable view of its financial performance. This metric falls under the broader category of corporate finance and is often considered a non-GAAP financial measure, meaning it is not strictly defined by Generally Accepted Accounting Principles (GAAP). Companies may adjust cash flow to remove or include specific items they believe distort the true underlying cash-generating ability of the business or to better compare themselves to peers.

The purpose of calculating Adjusted Average Cash Flow is to gain deeper insights into a company's sustainable cash-generating capacity, free from certain non-recurring, unusual, or non-cash items. While standard cash flow metrics derived from the cash flow statement provide a foundational understanding, adjusted cash flow can offer a clearer picture for analysis, particularly when evaluating a company's liquidity and its capacity to meet ongoing obligations or fund future growth.

History and Origin

The concept of adjusting financial metrics, including cash flow, has evolved alongside the increasing complexity of financial reporting and analysis. While the cash flow statement became a formally required financial statement in the United States in 1988 with FASB Statement No. 95, previous forms of "funds statements" existed as early as 1863³⁸. The Financial Accounting Standards Board (FASB) has continually refined its guidance on financial reporting, including Accounting Standards Codification (ASC) 230, which governs the presentation of cash flows³⁶, ³⁷.

The need for "adjusted" figures arose as companies sought to present financial performance in ways they believed more accurately reflected their core business, often excluding items that were non-cash, non-recurring, or otherwise deemed non-operational. This trend led to the proliferation of non-GAAP financial measures. The U.S. Securities and Exchange Commission (SEC) has provided guidance over the years to ensure that these non-GAAP measures are not misleading to investors and are reconciled to their most comparable GAAP equivalents³¹, ³², ³³, ³⁴, ³⁵. For instance, a detailed calculation of "adjusted cash flow from operations to adjusted average debt" has been publicly reported by companies, illustrating how specific adjustments are made to standard cash flow metrics for analytical purposes²⁹, ³⁰.

Key Takeaways

Adjusted Average Cash Flow is a non-GAAP financial metric derived by modifying a company's cash flow to highlight specific aspects of its cash generation.
It aims to provide a clearer view of a company's sustainable cash-generating ability by excluding or including particular items.
Adjustments often relate to non-cash expenses like depreciation and amortization, non-recurring items, or specific operational considerations.
This metric is used by analysts and management to assess a company's financial health, debt-servicing capacity, and ability to fund capital expenditures.
The use of adjusted cash flow measures must comply with regulatory guidance, such as that provided by the SEC for non-GAAP financial measures.

Formula and Calculation

The formula for Adjusted Average Cash Flow is not standardized and varies depending on the specific adjustments being made and the average period considered. Generally, it begins with a GAAP cash flow measure, most commonly cash flow from operating activities, and then applies specific modifications.

A common approach involves:

\text{Adjusted Cash Flow} = \text{Operating Cash Flow} \pm \text{Adjustments}

Where:

Operating Cash Flow: Cash generated from a company's normal business operations before considering investing or financing activities²⁷, ²⁸. This is typically found in the cash flow statement.
Adjustments: These can include adding back certain non-cash expenses, such as depreciation and amortization, or removing the impact of non-recurring gains or losses. It might also involve factoring in changes to working capital that are deemed non-representative of ongoing operations²⁵, ²⁶.

To calculate the average adjusted cash flow, the adjusted cash flow values for a specified period (e.g., several quarters or years) are summed and then divided by the number of periods.

\text{Adjusted Average Cash Flow} = \frac{\sum_{i=1}^{n} \text{Adjusted Cash Flow}_i}{n}

Where:

(\sum_{i=1}^{n} \text{Adjusted Cash Flow}_i) = The sum of adjusted cash flow for each period (i)
(n) = The number of periods

For example, a company might define its adjusted cash flow from operations as net cash provided by operating activities plus two-thirds of operating rent expense less capitalized interest expense for a given fiscal year or trailing twelve months²³, ²⁴.

Interpreting the Adjusted Average Cash Flow

Interpreting Adjusted Average Cash Flow involves understanding the specific rationale behind the adjustments and how they influence the perception of a company's true cash-generating ability. Since this is a non-GAAP financial measure, it is crucial to review the company's disclosures to understand what has been included or excluded and why.

A consistently positive and growing Adjusted Average Cash Flow generally indicates strong financial health and the capacity to generate sufficient cash internally to fund operations, repay debt, and potentially return value to shareholders. Conversely, a declining or negative trend, even after adjustments, could signal underlying operational challenges or an inability to sustain cash generation from core activities.

Analysts often use this metric to compare companies within the same industry, especially when their accounting practices for certain items might differ under GAAP, or when non-recurring events have significantly impacted reported cash flows. By normalizing for these differences through adjustments, a more "apples-to-apples" comparison can be made regarding operational efficiency and cash flow sustainability. It helps in assessing a company's liquidity and its capacity to fund future capital expenditures or other strategic initiatives.

Hypothetical Example

Consider a hypothetical manufacturing company, "Evergreen Innovations Inc." Evergreen Innovations reports the following operating cash flows over three years:

Year 1: $10,000,000
Year 2: $12,000,000
Year 3: $8,000,000 (affected by a one-time legal settlement outflow of $3,000,000)

The company's management believes the Year 3 cash flow is not representative of its ongoing operating activities due to the non-recurring legal settlement. They decide to calculate an Adjusted Average Cash Flow by excluding the impact of this settlement.

Step 1: Adjust Year 3 Operating Cash Flow

Reported Operating Cash Flow (Year 3) = $8,000,000
One-time legal settlement outflow = $3,000,000
Adjusted Operating Cash Flow (Year 3) = $8,000,000 + $3,000,000 = $11,000,000

Step 2: Calculate the sum of adjusted cash flows

Adjusted Cash Flow (Year 1) = $10,000,000
Adjusted Cash Flow (Year 2) = $12,000,000
Adjusted Cash Flow (Year 3) = $11,000,000
Total Adjusted Cash Flow over 3 years = $10,000,000 + $12,000,000 + $11,000,000 = $33,000,000

Step 3: Calculate the Adjusted Average Cash Flow

Number of years = 3
Adjusted Average Cash Flow = $33,000,000 / 3 = $11,000,000

In this example, the Adjusted Average Cash Flow of $11,000,000 provides a clearer indication of Evergreen Innovations' typical cash generation from its core operations, as it removes the distorting effect of the one-time legal settlement. This adjusted figure can then be used for more accurate forecasting or comparison of the company's long-term financial health.

Practical Applications

Adjusted Average Cash Flow is a valuable metric in various financial analyses and decision-making processes, offering a nuanced view beyond standard cash flow figures.

Credit Analysis and Lending: Lenders often scrutinize a company's cash flow to assess its ability to service debt. Adjusted Average Cash Flow can provide a more stable and reliable indicator of repayment capacity, especially when a company's reported cash flows are impacted by irregular events. It helps lenders gauge the recurring cash flow available for debt service and evaluate the overall financial health and risk profile of the borrower.
Valuation and Investment Decisions: Investors and analysts frequently use cash flow-based valuation models, such as discounted cash flow (DCF), to estimate a company's intrinsic value. Adjusted Average Cash Flow helps in projecting future cash flows more accurately by normalizing for non-recurring items or non-cash charges like depreciation and amortization, which can distort reported net income. This provides a more consistent basis for valuing a business and making informed investment decisions²².
Performance Evaluation and Management: Companies may use Adjusted Average Cash Flow internally to evaluate the efficiency of their operating activities and to set realistic performance targets. By adjusting for factors outside of core operational control, management can better assess the effectiveness of their strategies in generating sustainable cash. Monitoring this metric over time can reveal trends in cash generation and highlight areas for operational improvement.
Mergers and Acquisitions (M&A): During M&A due diligence, buyers will often recalculate a target company's cash flows to remove the impact of non-recurring items or to standardize accounting treatments for comparison. Adjusted Average Cash Flow provides a "normalized" view of the target's cash generation, helping the acquiring company determine a fair valuation and understand the ongoing cash flow potential post-acquisition.
Capital Allocation Decisions: Understanding the true recurring cash available is crucial for decisions regarding capital expenditures, dividends, share buybacks, and debt reduction. Adjusted Average Cash Flow helps management allocate capital effectively by identifying the sustainable surplus cash generated from core operations that can be reinvested in the business or returned to shareholders. The importance of strong cash flow to business stability and growth is well-documented²⁰, ²¹.

Limitations and Criticisms

Despite its utility, Adjusted Average Cash Flow, like all non-GAAP financial measures, comes with important limitations and criticisms.

Lack of Standardization: The primary criticism is the absence of a universally accepted definition or formula. Each company can define its "adjusted" cash flow differently, choosing which items to exclude or include based on its own discretion¹⁹. This lack of standardization makes direct comparisons between companies challenging, even within the same industry, and can lead to confusion for investors. The SEC has emphasized the need for clear reconciliation to GAAP measures and the potential for such adjustments to be misleading if they exclude normal, recurring cash operating expenses¹⁷, ¹⁸.
Potential for Manipulation: The flexibility in defining Adjusted Average Cash Flow can be exploited to present a more favorable financial picture than what GAAP measures might indicate. Companies might selectively remove expenses or add back non-cash items in ways that inflate the perceived cash-generating ability, potentially misleading investors about the true financial health of the business¹⁵, ¹⁶. For example, a company might argue that certain operational costs are "non-recurring" when, in fact, they are part of the normal business cycle.
Opacity and Complexity: The process of adjusting cash flow can introduce additional complexity into financial reporting. Unless clearly explained and reconciled, these adjustments can make it harder for an average investor to understand the underlying drivers of a company's cash flow. The reliance on non-GAAP metrics can obscure the complete financial picture provided by the comprehensive cash flow statement and other GAAP financial statements.
Exclusion of Essential Costs: Sometimes, adjustments might exclude costs that, while non-cash or irregular in timing, are essential for maintaining the business. For instance, if a company consistently faces large legal settlements or significant restructuring charges, adjusting these out could present an unrealistic view of the cash flow required to run the business effectively. Similarly, consistently excluding capital expenditures in certain "adjusted cash flow" metrics might misrepresent the actual cash needed to maintain and grow the asset base.

The Financial Accounting Standards Board and the SEC continue to issue guidance to ensure that companies provide adequate disclosures and reconciliations for non-GAAP financial measures to mitigate these risks and provide greater transparency¹², ¹³, ¹⁴.

Adjusted Average Cash Flow vs. Operating Cash Flow

Adjusted Average Cash Flow and Operating Cash Flow are both important metrics for assessing a company's financial liquidity and performance, but they serve different purposes and offer distinct perspectives. The key difference lies in their scope and the nature of their calculation.

Feature	Adjusted Average Cash Flow	Operating Cash Flow
Definition	A non-GAAP measure that takes standard cash flow (typically operating cash flow) and modifies it by adding or subtracting specific items deemed non-recurring, non-cash, or distorting to provide a more representative view of sustainable cash generation.	A GAAP measure that represents the cash generated or consumed by a company's core business activities, such as sales of goods and services, and payments for expenses. It is the first section of a company's cash flow statement.
Standardization	Not standardized; its definition varies from company to company, making direct comparisons difficult without detailed understanding of adjustments.	Standardized under Generally Accepted Accounting Principles (GAAP) (ASC 230) and International Financial Reporting Standards (IFRS), ensuring comparability.
Purpose	Used by management and analysts to highlight underlying cash-generating ability, remove noise from unusual items, and facilitate specific analytical comparisons.	Provides a fundamental view of a company's ability to generate cash from its primary business operations to cover day-to-day expenses and turn a profit.
Components	Starts with Operating Cash Flow and then applies specific adjustments, such as adding back unusual expenses (e.g., one-time legal settlements) or non-cash charges not typically added back in standard operating cash flow calculations (e.g., certain deferred revenue impacts).	Includes cash inflows from sales and cash outflows for operational expenses, excluding non-cash items like depreciation and amortization, and adjusting for changes in working capital¹¹.
Regulatory Oversight	Subject to SEC guidance for non-GAAP financial measures, requiring reconciliation to the most comparable GAAP measure and explanation of its usefulness⁹, ¹⁰.	Required financial disclosure under GAAP for all public companies, ensuring transparency and consistency⁶, ⁷, ⁸.

While Operating Cash Flow offers a clear and standardized view of cash from core operations, Adjusted Average Cash Flow provides flexibility to tailor the metric for specific analytical needs, often aiming to present a normalized or recurring cash flow figure.

FAQs

What types of adjustments are typically made to calculate Adjusted Average Cash Flow?

Adjustments often include adding back non-cash expenses such as depreciation, amortization, and stock-based compensation. Companies might also remove the impact of one-time gains or losses, restructuring charges, legal settlements, or other non-recurring items that are considered outside of normal operating activities ⁵. The specific adjustments can vary widely depending on the company's industry and the purpose of the adjustment.

Why do companies use Adjusted Average Cash Flow if Operating Cash Flow is already a standard metric?

Companies use Adjusted Average Cash Flow to provide a clearer picture of their sustainable cash-generating ability, free from the "noise" of non-recurring events or specific non-cash accounting entries that might distort the standard Operating Cash Flow. This can help investors and analysts better understand the underlying financial health of the business and compare it more effectively to peers, especially when assessing its capacity to cover capital expenditures or debt⁴.

Is Adjusted Average Cash Flow always a positive number?

No, Adjusted Average Cash Flow is not always a positive number. While companies typically aim for positive cash flow, even after adjustments, a business might experience periods of negative adjusted cash flow if its outflows consistently exceed its adjusted inflows. This could indicate significant investments, operational challenges, or other factors leading to a net cash drain, even when non-recurring items are excluded.

How does the SEC regulate Adjusted Average Cash Flow?

The SEC regulates Adjusted Average Cash Flow as a non-GAAP financial measure. This means companies must reconcile the adjusted measure to its most directly comparable GAAP financial measure (like cash flow from operating activities), present the GAAP measure with equal or greater prominence, and explain why management believes the non-GAAP measure provides useful information to investors. The SEC scrutinizes adjustments, especially those that exclude normal, recurring cash operating expenses¹, ², ³.

Can Adjusted Average Cash Flow be used for forecasting future cash flows?

Yes, Adjusted Average Cash Flow can be a useful input for forecasting future cash flows, as it aims to provide a normalized and sustainable measure of a company's cash generation. By removing the impact of one-time events or specific non-cash items, analysts can develop more reliable projections of a company's ongoing cash-generating capacity, which is critical for valuation models and strategic planning. However, it is essential to understand the nature of the adjustments and their potential impact on future periods.