Using “free cash flow” as an incentive measure: a checklist

More ASX 300 companies are using “free cash flow” (FCF) as a performance measure for incentive purposes. Free cash flow, despite it being a non-standard measure, can be an important performance indicator, and measure of value. However, being a non-standard metric, free cash flow can also be open to misuse and abuse. ASIC has recognised this to some extent in its requiring companies to provide clarity around the use of non-standard measures in directors’ operating and financial reviews (see HERE)


This has also been picked up by the proxy advisers, who scrutinise remuneration reports for use of non-standard financial measures and the extent they are consistent with ASIC’s RG 247 (see, for example, our review of the 2014 guidelines of proxy adviser ISS that first incorporated this reference HERE).


Free cash flow is typically calculated as cash flows from operating activities, a standard accounting metric, less capital expenditures. Equity analysts like to use free cash flow and another metric, free cash flow yield, which uses the last 12 months’ free cash flow per share divided by the current share price, to see whether free cash flow yield exceeds the dividend yield (see an analyst’s discussion HERE as an example).


If free cash flow yield does exceed the dividend yield, the company is thought to have “headroom” to raise dividends, or buy back stock, or make acquisitions, or otherwise expand the business, all of which can boost share prices over the long term.


In an echo of the ASIC’s RG 247, the SEC in the US has warned companies in its May 2016 guidelines (see HERE) that free cash flow does not have a universal definition and its title does not describe how it is calculated. Companies should be careful, the SEC wrote, to avoid “inappropriate or potentially misleading inferences” about the usefulness of any free cash flow metric.


For example, “free cash flow should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures,” according to the guidelines. This is the nub of the measure, i.e. the residual cash left over for discretionary expenditure, which may be used to pay down debt, increase dividends, buy back shares, invest for expanding productive capacity etc.

Guerdon Associates has provided a check list to assist remuneration committees’ consideration of, and reporting on the use of “free cash flow” measures for incentive purposes:

  • Is FCF an essential element to evaluate the achievement of company strategy?
  • Have you modelled the impact FCF would have had in the past on executive incentive payments had it been in place? How did it correlate with shareholder returns and incentive outcomes in that period?
  • Is this explained in the directors’ operating and financial review disclosures and in accord with ASIC RG 247?
  • Is FCF clearly defined in a way that is consistent with strategy? That is, is it expressed as a compound annual growth (CAGR) to encourage transformation, or a simple annual average to encourage sustainable improvement, or an absolute target FCF per share to meet yield expectations, or a $ target for a specific debt reduction purpose?
  • Is it transparent, so it can be reconciled with statutory AASB disclosures? Can the reconciliation be simply illustrated in the remuneration report? Importantly, can it be gamed?
  • Is FCF a measure over which management has direct influence and control, and over what time period? For example, companies significantly dependent on commodities as an input or output may be unlikely to have much direct influence on free cash flow in the short term once embarked on major capital expenditure programs to benefit longer term returns.
  • Can using FCF for an incentive plan have unintended consequences (e.g. the forsaking of more sustainable longer term returns to achieve short term free cash flow outcomes)?
  • Can targets be set that are consistent with guidance and/or market expectations, such that disclosure of targets will receive proxy adviser and investor support?
  • What are the consequences, if any, of impairments not usually captured by a FCF measure? Should management be made to wear the cost for previous applications of free cash to make a poor investment? How, via lower incentive payment or malus? If so, should this be discretionary or formulaic, applicable to all, or just those who influenced the decision? Is this policy to be disclosed?
  • Will the FCF be in line with statutory accounting NPAT measures in the performance period? If going in different directions is there sufficient discussion and a robust defence of the measure? Or would it be better to consider an NPAT gateway prior to considering the extent of free cash performance achieved for incentive purposes?

In the reviewing the above, also consider it in combination with Guerdon Associates matters for consideration when using an underlying or normalised earnings measure (see HERE).

In many respects the issues identified with FCF relate to earlier commentary by the head of the IASB on the use of underlying earnings for reporting purposes (see HERE).

© Guerdon Associates 2024
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