An Unexpected Free Cash Flow Comment from the SEC Staff

It is surprising how much attention free cash flow continues to generate in SEC disclosures. After all, it’s been used for decades as a non-GAAP financial measure. In fact, back in 2003, the SEC’s non-GAAP financial measure FAQs stated that companies should be “cautious” when using it, noting that it does not have a uniform definition and might inappropriately imply that it represents residual cash flow available for discretionary expenditures.

Fast forward to the much-scrutinized 2016 non-GAAP financial measures C&DIs, which essentially repeated the old free cash flow FAQ, though now companies need only be “aware” of, rather than “cautious” about, the absence of a uniform definition. This softer language presumably reflects the staff’s general softening toward non-GAAP measures, which it now sees as helpful disclosure so long as it’s done properly.

Then unexpectedly (at least to me), Monsanto Company received the following comment in a February letter that appears to have resulted from the staff’s routine review of Monsanto’s Form 10-K:

“We note you define free cash flow as the total of net cash provided or required by operating activities and net cash provided or required by investing activities. Pursuant to Question No. 102.07 of the Staff’s Compliance & Disclosure Interpretations (“C&DIs”) on Non-GAAP Financial Measures, issued May 17, 2016, please advise of your consideration given to redefining this measure or its computation as the typical calculation of free cash flow (i.e., cash flows from operating activities less capital expenditures). Please provide us with any proposed revisions to your disclosure of free cash flow to be included in future filings.”

The comment seems inconsistent with the staff’s position that free cash flow does not have a uniform definition and that companies need simply provide a “clear description of how this measure is calculated.” The staff expresses no issue with the clarity of Monsanto’s description, but rather just doesn’t seem to like the definition itself.

In response, Monsanto defended itself quite capably, noting that “[t]he Staff’s guidance (i) confirms that disclosure of free cash flow is not prohibited in filings with the Securities and Exchange Commission, (ii) calls for ‘a clear description of how this measure is calculated’ along with an appropriate reconciliation, and (iii) advises issuers to avoid ‘inappropriate or potentially misleading inferences about its usefulness.’” Monsanto correctly states that it already provides clear disclosure of how free cash flow is calculated, acknowledges the limitations of the measures, provides an appropriate caution to investors, explains how the company uses the measure and why it believes the measure is useful to investors, and cross-references to the reconciliation table. Monsanto also notes that it “has used this definition of ‘free cash flow’ since 2002, and is not aware of any investor confusion.”

Nevertheless, Monsanto apparently decided that discretion is the better part of valor and acceded to the staff’s wishes by agreeing to adopt the “typical” definition (net cash provided by operating activities less capital expenditures) in future filings.

One wonders how hard the staff would have pushed back if Monsanto had not so agreed. I’m guessing the staff would have let it drop upon having confirmed through Monsanto’s response that it had given the issue appropriate consideration.

In any event, it’s something to watch for if your company’s free cash flow definition deviates from the norm.

All the best,

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