I recently edited an article on CVS (NYSE:CVS) written by Steven Mallas. The original article talked about how CVS has been free-cash-flow negative for a few years. The definition of free cash flow used in the article was the simple and popular one: cash flow from operations minus capital expenditures.

Shortly after we published the article, Steve forwarded me an email from CVS's Investor Relations group saying that by not adding back the line item in the cash-flow-from-investing section labeled "Proceeds From Sale-Leaseback Transactions" in CVS's report, the article omitted an important component of the company's free-cash-flow calculation. Adding those numbers back in turned the free-cash-flow results positive over the same time period. (See the table at the end of this article.)

Here's what got me thinking
This email from CVS sent up a red flag for me. So I decided to dig deeper to understand why the sales-and-leaseback proceeds should be subtracted from capital expenditures.

In the company's 2004 10-K under the heading "Liquidity and Capital Resources," we find the following:

Net cash used in investing activities increased to $3,163.3 million in 2004. This compares to $753.6 million in 2003 and $735.8 million in 2002. The increase in net cash used in investing activities during 2004 was due to the acquisition of . Acquired Businesses, as well as higher additions to property and equipment. Gross capital expenditures totaled $1,347.7 million during 2004, compared to $1,121.7 million in 2003 and $1,108.8 million in 2002. During 2004, approximately 56% of our total capital expenditures were for new store construction, 21% for store expansion and improvements and 23% for technology and other corporate initiatives.

We finance [emphasis added] a portion of our new store development program through sale-leaseback transactions. Proceeds from sale-leaseback transactions totaled $496.6 million in 2004. This compares to $487.8 million in 2003 and $448.8 million in 2002. Under the transactions, the properties are sold at net book value and the resulting leases qualify and are accounted for as operating leases.

To CVS's credit, there is a nice breakdown of capital expenditures by growth and maintenance, as well as an explanation of the sale and leaseback transactions. This clarity makes an investment analyst's job easier.

But if sale and leaseback transactions finance a portion of new store development, why don't the proceeds go under "Cash Flow From Financing" rather than "Cash Flow From Investing"?

A plausible alternative
Let's say a company makes an investment in a factory. The company spends cash to take ownership of the assets and does so to generate enough future cash flow to make a return on its investment. That's business.

If the company decides to sell the factory, it receives cash as it disposes of the assets. But as a result of the sale, it relinquishes access to the asset and is free to invest the proceeds wherever it believes it can earn a good return. Presumably, the factory wasn't generating good returns or the company had a better place to use the capital raised by selling the factory.

But is that the same for a sale-and-leaseback transaction? In that case, a company invests cash in an asset to generate returns. Then the company sells that asset and leases it back from the new owner. So while the company receives cash from the new owner after the sale, it also retains access to the asset in order to generate returns. And since CVS uses its leaseback proceeds to open new stores, could those sale-and-leaseback transactions be considered financing events, especially since the transactions now cause CVS to pay out interest payments in the form of rent?

I think it is certainly plausible.

But if CVS leased the properties from day one, that would have the same effect as the sale and leaseback transaction, which is to reduce the amount of capital expenditures. Thus, I can see the argument to account for the sale-and-leaseback proceeds as investment cash flows.

Since both scenarios about how to account for the transactions make sense, I decided to consult some accounting experts to check my thinking.

Accountants weigh in
In my search for enlightenment, I came across a paper (link opens a PDF file) titled "Cash-Flow Reporting Practices for Sale and Leaseback Transactions" by Dr. Charles Mulford and Amit Patel at the Georgia Tech Financial Analysis Lab. Although the article gives some interesting data, it appears that my search for certainty will have to continue.

The main takeaway from the paper is that there is no standard for how companies account for sale-and-leaseback transactions with operating leases. In other words, make sure you think critically about the cash flows reported. Of the 37 companies studied in this group, 30 companies, including CVS, reported the proceeds under "Cash Flow From Investing." The others reported the proceeds as "Cash Flow From Financing."

Sale-and-leaseback transactions as a percentage of capital expenditures


FY 2001

FY 2002

FY 2003

FY 2004





















Krispy Kreme*





*Through the first six months of FY 2004.

Using the table above, we see that the company most comparable to CVS is CarMax (NYSE:KMX), given that it uses sale-and-leaseback transactions consistently and heavily. Tweeter Home Entertainment (NASDAQ:TWTR), an electronics retailer, has used the transaction more sparingly.

One interesting comparison is between O'Charley's (NASDAQ:CHUX), the casual-dining restaurant, and doughnut dynasty Krispy Kreme (NYSE:KKD). Both have used sales and leasebacks sparingly to pay down existing debt. O'Charley's management accounted for it as a financing transaction -- raising capital to pay down debt. Krispy Kreme accounted for it as an investing transaction -- disposal of assets. How interesting that both companies have the same motivation yet very different accounting treatments!

According to Mulford and Patel, as well as a conversation with Bern Beatty, my accounting professor at Wake Forest, that's the real issue: The lack of hard guidelines can make comparables difficult. So it's up to the analyst to be very careful and very critical of companies and how they account for sale-and-leaseback transactions.

Ongoing basis
CVS uses this transaction on an ongoing basis. Furthermore, CVS uses sales and leasebacks across a similar percentage of its capital expenditures. And if you compare the proceeds with capital expenditures strictly for growth in new stores, the numbers rise to around 70%. Moreover, the sale-and-leaseback transactions happen soon after the stores open rather than sporadically when the company needs capital. As such, I think it is very reasonable to net the proceeds against the capital expenditures in order to measure the free cash flow generated. Had CVS not met the above criteria, I would be inclined to view it more as a financing operation.

The Foolish bottom line
The point here is that the notion of free cash flow is much more art than hard science. The idea of a series of "inputs" yielding a steadfast and true output is simply not a reasonable expectation, as my analysis reveals. I felt that this sort of topic offered an excellent opportunity to dig into the financials, providing the sort of analytical depth that a cursory glance at free financial sites usually cannot provide.

Free-cash-flow results at CVS






Cash Flow From Operations






Capital Expenditures












Free Cash Flow






Free Cash Flow With S-L






Dollars in millions.

Krispy Kreme is a Motley Fool Stock Advisor recommendation.

David Meier does not own shares in any of the companies mentioned and would like to thank Bern Beatty for helping him learn to think critically. The Motley Fool has a disclosure policy .