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.
Cash Flow Trends and Their Fundamental Drivers: Comprehensive Review
Quarter 2, 2014
Free Cash Margin Index:
2.43%, 3.96% (Mar. 2001, Dec. 2008)
3.97% (June 2014)
7.18% (Mar. 2010)
In Q2 2014, median free cash margin decreased for the third consecutive quarter to 3.97% for the twelve months ended June 2014, from 4.38% for the twelve months ended March 2014, also down from 4.63% in June 2013. This is the lowest free cash margin level we have seen since December 2008 and the metric has now declined below its previously narrow range of between 4.5% and 5.0%. An increase in the overall cash cycle, driven by an increase in receivables days and a decrease in payables days, and a decrease in operating cushion driven by a decrease in gross margin were the primary drivers of the decrease, outweighing the decrease in capital expenditures to revenue.
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 $739.70 million, up from $725.47 million for the twelve months ended March 2014. However, median revenues are only at 93.8% of their peak of $788.50 million during the period ending December 2012. While often a decline in free cash margin attributed to a rise in capital expenditures and inventory investments is good news, our data does not fully support this case. Capital expenditures to revenue is down to 3.47% from 3.52% the previous quarter and its year-over-year decline from 3.60% would signal a slow-down in the U.S. economy. Although up slightly since last quarter, inventory has declined to 22.35 revenue days from a year prior at 23.85 revenue days. Further, our sample’s decrease in core profitability against a rise in sales suggests concern behind the reduction in free cash margin. Evidenced by the decline in gross margin, it appears revenue has increased due to discounting. Although consistent with the Fed's view that inflation remains stubbornly below its target of 2%, this pricing pressure is not consistent with an economy that is growing sustainably. Overall, second quarter data of 2014 do not imply a strong and strengthening economy.
Looking at individual industries, during the June 2014 reporting period, free cash margin was stable in twenty-three industries, higher in five and lower in sixteen.
Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.
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.