Emphasis on Free Cash Flow and its Implications for Real Activities

Abstract

We examine the association between reporting free cash flow in the earnings announcement and real activities targeted at maximizing free cash flow. We find that firms reporting free cash flow engage in abnormally low capital expenditures and accelerate their cash receipts from customers, thereby maximizing near term free cash flow. This disproportionate emphasis on free cash flow is associated with lower GAAP earnings performance for the same level of free cash flow performance. We also find that firms appear to combine free cash flow and EBITDA to mitigate the real activity implications of either of the individual measures. Whereas EBITDA reporting is associated with high investment and free cash flow is associated with low investment, firms that report EBITDA and free cash flow do not invest abnormally. Further, reporting EBITDA alongside free cash flow appears to mitigate the tendency of firms reporting free cash flow alone to accelerate cash receipts from customers. Overall, our evidence suggests that managers report non-GAAP metrics that are consistent with the way they define and make decisions to maximize differing measures of operating performance.

Keywords: Corporate Investment; Non-GAAP Metrics; Free Cash Flow; EBITDA, Non-GAAP, Free Cash Flow, Capital Expenditures, EBITDA, Cash Conversion Cycle

JEL Classification: G31, M21, M41