LIQUIDITY BY STRATEGIC BUSINESS UNIT
U.S. tax operations:
U.S. tax operations is the largest provider of operating cash flows to the Company. Free cash flow, defined as U.S. tax operations’ net earnings plus amortization and depreciation expense, was $382.5 million in fiscal 2002 and $323.8 million in fiscal 2001. Relative to revenues of $1.8 billion and $1.6 billion in fiscal 2002 and 2001, free cash flow represents 20.9% and 20.0% of revenues, respectively. Management believes these cash flows to be predictable and recurring in nature.

RAL participation funding totaled $4.6 billion in fiscal 2002, compared with $3.6 billion in fiscal 2001. The peak RAL-related receivable balance was $1.6 billion in fiscal 2002. These participation interests were funded by operating cash flows and commercial paper borrowings. Interest expense related to the RAL product was $3.9 million and $3.3 million in fiscal years 2002 and 2001, respectively.

International tax operations:
International tax operations are generally self-funded. Cash flows are held in Canada, Australia and the United Kingdom independently and in local currencies and are not repatriated. H&R Block Canada has a $125 million commercial paper program. At April 30, 2002, there was no commercial paper outstanding. The peak borrowing during fiscal year 2002 was $43.0 million.

Mortgage operations:
Through Option One and H&R Block Mortgage Corporation, this segment primarily originates, services, and sells non-conforming and conforming mortgage loans. In an effort to reduce the Company’s capital investment in its mortgage operations, the Company entered into third-party off-balance sheet arrangements beginning in April 2000, renewable annually. The arrangements, which are not guaranteed by the Company, have freed up cash and short-term borrowing capacity ($1.1 billion at April 30, 2002), improved liquidity and flexibility, and reduced balance sheet risk, while providing stability and access to liquidity in the secondary market for mortgage loans. See note 5 in the consolidated financial statements for additional information on the Company’s residuals.

The Company originates mortgage loans and sells most loans the same day in a whole-loan sale to a third-party trust (“Trust”). The sale is recorded in accordance with Statement of Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The Trust purchases the loans from the Company utilizing warehouse facilities the Company has not guaranteed. The warehouse facilities are provided by two third-party financial institutions that have each provided $1 billion. These facilities are subject to various performance triggers and limits, and financial covenants including tangible net worth and leverage ratios. Option One is well within the range of these triggers. The Trust is solely responsible for paying principal and interest on the warehouse financing arrangement. As a result of the whole-loan sale to the Trust, the Company records a receivable from the Trust for the present value of the portion of the net spread (the difference between the note rate on the loans and the financing cost of the trust) plus prepayment penalty income. This receivable is included in prepaid and other current assets on the consolidated balance sheets. The Company then pledges its receivable and the Trust pledges the related mortgage loans to a securitization trust to reconstitute the loans. The securitization trust then securitizes the reconstituted mortgage loans. At this point, the Company’s receivable is recharacterized as a residual interest from the securitized mortgage loans. These residual interests are classified as trading and are included in marketable securities-trading on the consolidated balance sheets.

To enable the Company to accelerate a significant portion of the cash flow from residual interests rather than over the life of the securitization, the Company securitizes its residual interests in a net interest margin (“NIM”) transaction. From the NIM transaction, the Company receives cash and retains a much smaller residual interest. Generally, these residuals do not begin to receive cash collections for two to three years. These residual interests are classified as available-for-sale.

The Company began receiving cash collections from its residual interests in fiscal 2002 which reduces the outstanding balance of the residuals. Cash received on these residual interests for fiscal 2002 was $67.1 million.

The Company has commitments to fund mortgage loans of $1.7 billion at April 30, 2002, subject to contract verification. External market forces impact the probability of loan commitments being closed, and therefore, total commitments outstanding do not necessarily represent future cash requirements. If the loan commitments are exercised, they will be funded in the manner described above.

The mortgage segment regularly sells whole loans as a source of liquidity for its prime and non-prime mortgages. Whole loan sales in fiscal year 2002 were $11.4 billion compared with $6.0 billion in 2001. Additionally, the Company provides the mortgage division a $150 million line of credit for working capital needs.

Management believes the sources of liquidity available to the mortgage operations segment are predictable and sufficient for its needs. Risks to the stability of these sources include external events impacting the asset-backed securities market. The liquidity available from the NIM transactions is also subject to external events impacting this market. These external events include but are not limited to spread widening, adverse changes in the perception of the non-prime industry or in the regulation of non-prime lending and reduction in the availability of third parties that provide credit enhancement. Performance of the NIM transactions will also impact the segment’s future participation in these markets. The warehouse facilities used by the Trust are subject to annual renewal in April and any of the above events could lead to difficulty in renewing the lines. These risks are mitigated by the availability of whole-loan sales and financing provided by the Company.

Investment services:
Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in brokerage client accounts and working capital. Management believes these sources of funds will continue to be the primary sources of liquidity for HRBFA. Stock loans are often used as a secondary source of funding as well.

HRBFA is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers.

HRBFA is required to maintain minimum net capital as defined under Rule 15c3-1 of the Securities Exchange Act of 1934 and has elected to comply with the alternative capital requirement, which requires a broker-dealer to maintain net capital equal to the greater of $1 million or 2% of the combined aggregate debit balances arising from customer transactions. The net capital rule also provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than the greater of 5% of combined aggregate debit items or $1 million. At April 30, 2002, HRBFA’s net capital of $143.5 million, which was 16.42% of aggregate debit items, exceeded its minimum required net capital of $17.5 million by $126.0 million.

To manage short-term liquidity, HRBFA maintains a $300 million unsecured credit facility with BFC, its immediate corporate parent. Additionally, HRBFA maintains a $50 million uncommitted, collateralized pledge facility for settlement purposes with the clearing organizations. As of April 30, 2002 and 2001, there were no outstanding balances on these facilities.

Securities borrowed and securities loaned transactions are generally reported as collateralized financings. These transactions require the Company to deposit cash and/or collateral with the lender. Securities loaned consist of securities owned by customers, which were purchased on margin. When loaning securities, the Company receives cash collateral approximately equal to the value of the securities loaned. The amount of cash collateral is adjusted, as required, for market fluctuations in the value of the securities loaned. Interest rates paid on the cash collateral fluctuate as short-term interest rates change.

To satisfy the margin deposit requirement of client option transactions with the Options Clearing Corporation (“OCC”), HRBFA pledges customers’ margined securities. Pledged securities at April 30, 2002 totaled $42.8 million, an excess of $4.0 million over the margin requirement. In April 2001, HRBFA provided the OCC with letters of credit of $68.0 million to satisfy the $63.8 million margin requirement. The letters of credit were collateralized by customers’ margined securities.
Management believes the funding sources for HRBFA are stable. Liquidity risk within HRBFA is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.

Business services:
Business services funding requirements are largely related to “work in process.” A line of credit is available from the Company sufficient to cover this unit’s working capital needs.

Business services has commitments to fund certain attest entities, that are not consolidated, related to accounting firms it has acquired. Commitments also exist to loan up to $40 million to McGladrey & Pullen, LLP on a revolving basis through July 31, 2004, subject to certain termination clauses. This revolving facility bears interest at the prime rate plus four and one-half percent on the outstanding amount and a commitment fee of one-half percent per annum on the unused portion of the commitment.

Business services also has future obligations that are summarized in the table above under “Other Obligations and Commitments.”

CAPITAL RESOURCES
Cash provided by operations totaled to $741.4 million during fiscal 2002 as compared to $248.4 million in the prior year. Cash provided by operations was impacted by the net profits from operations of $434.4 million for fiscal 2002 compared to a net profit of $281.2 million in fiscal 2001.

Cash expenditures during fiscal year 2002 relating to investing and financing activities include the purchase of property and equipment ($111.8 million), business acquisitions ($46.7 million), payments on acquisition debt ($50.6 million), payment of dividends ($115.7 million) and the acquisition of treasury shares ($267.7 million net of the proceeds from issuance of common stock).

Cash and cash equivalents, including restricted balances, totaled $588.3 million at April 30, 2002. HRBFA held $256.8 million of the $588.3 million, of which $108.0 million was segregated in a special reserve account for the exclusive benefit of customers pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934 (restricted cash). The HRBFA restricted cash balance has grown from $16.0 million at the beginning of fiscal 2002 to $108.0 million at April 30, 2002. Customer credit balances have become larger than customer debit balances due to the significant decline in margin loan balances resulting from the slowing economy, while customer credit balances have increased slightly during the period. The remaining cash and cash equivalents held by HRBFA reflect excess cash remaining from the firm and clients after funding margin debits and security settlements. Restricted cash held by Mortgage operations totaled $32.1 million at April 30, 2002 as a result of cash held for outstanding commitments to fund mortgage loans. Restricted cash of $12.0 million at April 30, 2002 held by Business services is related to funds held to pay payroll taxes on behalf of their customers. The remaining balance of cash and cash equivalents held reflects net operational cash flow.