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Investing, Warren Buffett says, is easy: Just add up all the future cash flows of a business, discount them to the present day, and pay less than that number.

Set aside, for the moment, that those future cash flows are somewhere between estimate and guesstimate. Sometimes, the problem for investors is figuring out just what cash flow number to use.

For examples, we turn to two of the buzziest Internet companies today: Groupon Inc. , which just reported its first quarterly results as a public company, and Facebook Inc., which tantalized investors this month with its initial public offering filing.

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First, let's talk about the cash flow statement. Operating cash flow takes the company's net income and adds back non-cash expenses, such as depreciation, to arrive at a number for how much cash the company generated from its operating business.

The number is distinct from investing cash flow, which records cash spent on things like property, plant and equipment, and financing cash flow, which considers, for example, what the company borrows or the debt it pays off.

The cash flow statement is (or should be) created per generally accepted accounting principles, or GAAP, in the United States, or International Financial Reporting Standards in Canada. (IFRS allows companies discretion as to where they put their interest payments, meaning that operating cash flow at a Canadian company may not be directly comparable with a U.S. company. That is a topic for another day.)

Operating cash flow is not the end of the story, however. Analysts and companies recognize that continuing capital expenditures – the purchases of plant property and equipment – are necessary to generate operating cash. So, the number that emerges is often called "free cash flow" – typically, but not universally, defined as operating cash flow minus capital expenditures. Why is it not universal? There's no explicit definition for "free cash flow" in the accounting standards.

Now, we turn to Facebook. Two professors who run the Grumpy Old Accountants blog give the company an "A" grade for its financial reporting. They laud Facebook for not using EBITDA, or earnings before interest, taxes, depreciation and amortization, anywhere in their financial statements.

More narrowly, but also importantly, they also credit Facebook for its definition of free cash flow: From operating cash flow, the company subtracts not only purchases of capital equipment, but also payments on leases used to acquire it.

Facebook says it made the choice "because we believe that these two items collectively represent the amount of property and equipment we need to procure to support our business, regardless of whether we finance such property or equipment with a capital lease."

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Say the Grumpy Old Accountants, Anthony H. Catanach Jr. and J. Edward Ketz: "Yes, this is a small thing, but it suggests that the company values good numbers, not 'make believe' metrics."

"Make believe," like what? Well, like some of the measures Groupon has tried to use. (This is VOX's third shot at Groupon, and perhaps its last, but I cannot promise.)

Groupon initially tried to make up its own "consolidated segment operating income" metric that left out all sorts of real expenses. The Wall Street Journal reported that the U.S. Securities and Exchange Commission took issue with this approach, and Groupon removed it from its IPO filing.

Groupon seems to be getting more rigorous, as evidenced by its earnings release last week that highlighted free cash flow. And indeed, Groupon calculated it in a traditional way, subtracting capital expenditures from operating cash flow.

But the Grumpy Old Accountants, in an interview with CFO magazine, made another valid criticism of Groupon's financial reporting.

The company's business model, where it sells online coupons and eventually passes the proceeds on to its merchant partners, offers great room to stretch out payment times and improve operating cash flow. That's because part of the measure includes the changes in a company's payables and receivables – so a company that takes longer to cover its bills can, appropriately, report a better cash flow number than a company that pays faster.

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Since Groupon didn't provide the entire cash flow statement with its earnings release, Mr. Catanach said, it's difficult to determine whether vendor-payment policies contributed to its increases in free cash flow. Groupon chief financial officer Jason Child responded to the comments by telling CFO magazine the suggestion was untrue and "silly," and that providing a full cash flow statement would not give investors "any additional information."

Untrue, perhaps, but not silly, since Groupon didn't produce the cash-flow statement that would have quashed any such concerns. It was, indeed, "additional information" – information that is deeply important for investors to unravel the mysteries of cash flow.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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