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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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The Effects of Tax Reform on Deferred Taxes: The Winners and Losers

February 2015

In this study, we examine the impact of US corporate income tax reform on deferred taxes. Our objective is to identify those companies and industries that stand to gain and those that stand to lose from a potential decrease in the U.S. corporate tax rate. 

Deferred tax assets are the tax savings arising from future tax deductions. Deferred tax liabilities reflect taxes due on future taxable amounts. Both deferred tax assets and deferred tax liabilities are measured using tax rates expected to be in effect when underlying deductions or taxable amounts are realized. A reduction in the corporate tax rate, expected with tax reform, would reduce reported deferred tax assets and liabilities, resulting in decreases in assets and shareholders’ equity for some firms and decreases in liabilities with increases in shareholders’ equity for others. For a sample of 809 U.S. companies with reported deferred tax balances, we present the financial statement effects of lowering the corporate income tax rate from 35% to 28%. 

Overall, we find that 548 sample companies with deferred tax liabilities will enjoy a $142.4 billion reduction in liabilities and increase in shareholders’ equity. Industries impacted the most include the utilities, oil and gas and transportation firms. In contrast, we find that 261 sample firms with deferred tax assets will see assets and shareholders’ equity decline by $38.2 billion. On this score, the Financials is the industry that is affected the most. 

Equity and credit analysts, investors and creditors will want to evaluate the effects of tax reform on the financial position of portfolio companies. Corporate managers will want to gauge the potential effects of tax reform on their firms’ assets, liabilities and shareholders’ equity and evaluate those effects on existing debt covenants.


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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.


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