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The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants.

Because our lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large.

A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times our research may look at stock prices generally, though from a fundamental and not technical point of view.

 


Quarter 3, 2014
Earnings Quality Indicator:
Pre-Recession

4.55% (Jun. 2007)

Current

4.84% (Sep. 2014)

Recent High

8.58% (Dec. 2009)

March 2015

During the recent financial crisis, median earnings quality, measured using EQI or operating cash margin less net margin, has increased dramatically and then fallen to pre-recession levels. In a January 2013 Report, the Georgia Tech Financial Analysis Lab noted the return of EQI to normal levels. Today, we revisit earnings quality trends by observing the median EQI for 44 non-financial industries. Median EQI for all non-financial industries rose slightly from 4.56% for the twelve months ending June 2012 to 4.84% for the twelve months ending September 2014.

This 6.14% rise in EQI demonstrates stabilization of earnings quality trends around normal levels. Companies found an equilibrium ratio of operating cash flow to revenue as the effects of reducing inventories and of taking longer to collect payment of operating receivables offset. However, net margins suffered as operating cushion percent was reduced by weaker gross margins. Companies may continue to see gross margin reversion from recent highs as labor seeks greater claims on revenue and new entrants fueled by easy credit are able to enter markets.

A falling EQI raises questions about the sustainability of future earnings. In a similar fashion, a rising EQI raises questions about the sustainability of future operating cash flow. A stable EQI, showing no discernible trend, is one that does not raise such questions about the sustainability of future earnings or operating cash flow. While EQI did show a significant increase during the recession and a decline after the recession ended, EQI has stabilized at a level that existed prior to the recent recession. In future periods we expect EQI to trend around current levels. Significant increases or declines from this level could be cause for concern.

Regarding individual industries, during the period between June 2012 and September 2014, EQI was stable in 17 industries, increased in 13 and declined in 14. In this report we take a closer look at one individual industry where EQI has risen dramatically, Aircraft.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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Quarter 3, 2014
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.01% (Sep. 2014)

Recent High

7.18% (Mar. 2010)

January 2015

In Q3 2014, median free cash margin increased slightly to 4.01% for the twelve months ended September 2014, from 3.97% for the twelve months ended June 2014, but down from 4.68% in September 2013. The metric is now at the low end of its historical range for stability between 4.00% and 5.00%. A decrease in the overall cash cycle, driven by a decrease in receivables days and an increase in payables days, was the primary driver of the increase.
Although modest, the growth in revenues within the sample suggests the economy continues to move in the right direction. Median revenues within our sample increased to $774.50 million, up from $739.70 million for the twelve months ended June 2014. Median revenues are at 98.2% of their peak of $788.50 million during the period ending December 2012. The slight rise in free cash margin would have been more substantial but for inventory investments, the primary drag on free cash margin comparative to the twelve months ended June 2014. Inventory is up slightly since last quarter and is now at 22.52 revenue days, although it is down from a year prior of 23.74 revenue days. Inventory investment coupled with stable gross margin percentage can signal an improving economy, but the changes may be too slight to be conclusive in this case. Capital expenditures to revenue held steady from the previous quarter at 3.47%, off from one year ago at 3.50% and 94.8% of its five year high of 3.66%. Weak capital expenditures do not signal a strengthening U.S. economy but rather management uncertainty, especially in light of the current low interest rate environment. Companies have continued to resist using the Fed’s easy money policies to invest for growth. Overall, accounting data for the twelve months ending with the third quarter of 2014 does not imply a strong and strengthening economy.

Looking at individual industries for the reporting period ending September 2014, free cash margin was stable in twenty-two industries, higher in nine, and lower in thirteen.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


Download this Report

View Past Reports

 

Earnings Quality: Reports on Individual Companies


In these reports we examine one or more dimensions of earnings quality: the cash flow support of earnings, the sustainability of earnings, or the quality of the balance sheet.

Download

EQI, The Cash Flow Support of Earnings: Industry Review, 01.08.13

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EQI, the Cash Flow Support of Earnings:  Great Lakes Dredge, 04.07.13

Download

The Sustainability of Earnings: Selected Companies, 12.09.14

Download

EQI, The Cash Flow Support of Earnings: Industry Review, 03.02.15

 

Excel Spreadsheets of Cash Flow Data and Graphs by Industry


Quarter 3, 2014

0. All Industries (non-financials)
1. Agriculture
2. Food Products
3. Candy & Soda
4. Beer & Liquor
5. Tobacco Products
6. Recreation
7. Entertainment
8. Printing & Publishing
9. Consumer Goods
10. Apparel
11. Healthcare
12. Medical Equipment
13. Pharmaceutical Products
14. Chemicals
15. Rubber & Plastic Products
16. Textiles
17. Construction Materials
18. Construction
19. Steel Works
20. Fabricated Products
21. Machinery
22. Electrical Equipment


23. Automobiles & Trucks
24. Aircraft
25. Shipbuilding & Railroad Equipment
26. Defense
27. Precious Metals
28. Non-metallic & Industrial Metal Mining
29. Coal
30. Petroleum & Natural Gas
31. Utilities
32. Communication
33. Personal Services
34. Business Services
35. Computer Hardware
36. Computer Software
37. Electronic Equipment
38. Measuring & Control Equipment
39. Business Supplies
40. Shipping Containers
41. Transportation
42. Wholesale
43. Retail
44. Restaurants