VideoIs the recent upturn in U.S. corporate profits likely to last? Unfortunately, a new study comparing trends in cash flow with those in earnings for the largest blue-chip companies provides ample reason for doubt.
The study, by the Financial Analysis Lab at the Georgia Institute of Technology's DuPree College of Management, found a troubling gap between cash flow from operations and operating income last year for the 87 nonfinancial members of the S&P 100. DuPree found that the difference between operating cash flow and income last year for the median company in the group was almost 12 percent greater than average for the three years that ended in 2002.
While a small gap of this sort (which DuPree terms a company's excess cash margin, or ECM) is not necessarily a troubling sign (whether positive or negative), a positive ECM in double digits reflects a heavy dependence on improvements in working capital and other boosts to cash flow that aren't sustainable, simply because such gains aren't generated by the growth of a company's underlying business operations.
Unless more sustainable growth has materialized in 2003, which at this point is impossible to determine, the study suggests that operating cash flow will soon decline. So, ultimately, will earnings, observes Charles Mulford, an accounting professor who oversees the Georgia Tech lab. (Mulford is aided by analyst Michael Ely.) "At least some of the recent improvement in cash flow is from liquidating the balance sheet; it is not earnings-produced," says Mulford. And, he asserts, "that kind of growth is not as sustainable."
Ideally, in Mulford's view, operating cash flow and earnings should grow more or less evenly over time. When they don't, and one measure exceeds the other by a large margin, there's reason to doubt that a company's performance is as strong as either measure alone may suggest.
Mulford's conclusions reflect the lab's efforts to adjust the S&P 100's figures for cash flow from operations and for net income for what the researchers consider nonrecurring and nonoperating items (see "Studying the Flow", at the end of this article). Last year, a study by DuPree did the same with cash flow from operations alone (see "Tuning In to Cash Flow," CFO, December 2002).
Off the Median
Of course, median figures paint the index's performance picture with a particularly broad brush, and individual company performances vary widely. More than a few companies, in fact, have been doing much better than average. Among the standouts: Anheuser-Busch, Coca-Cola, and Wal-Mart Stores, each of which showed gaps between operating cash flow and income in 2002 that were less than 10 percent greater than the mean for the three-year period.
To be sure, 19 other companies exhibited ECM differentials of less than 10 percent for the period (see, "The ECM Scale" at the end of this article). But in many of those cases, including Oracle, Entergy, and Home Depot, a relatively low average ECM for the three years obscured wider year-to-year swings, which Mulford says may themselves be reasons for concern. "My hunch is that volatility in ECM reflects greater risk," he says. And he contends that in some of these cases, such volatility may also reflect questionable accounting practices, though he's quick to say, "I don't want to point any fingers."
On the other hand, Mulford concedes that it's more difficult to see such practices at work in reported earnings—based as they are on undisclosed estimates—than in reported cash flow.
What's more, there's a natural gap between operating cash flow and income at any given time, simply because depreciation and amortization are reflected in net income but not in operating cash flow. As a result, Mulford explains, companies with small positive gaps between cash and income are likely to be performing better than those with equally small negative ones. Naturally, any gap will be much larger for capital-intensive companies and those with heavy investments in intangibles.
The Fundamentals
But while the ECM results provide only a snapshot of operating performance, closer scrutiny shows the metric reflects fundamental strength, or lack thereof. At Anheuser-Busch Cos., adjusted operating cash flow increased 20.4 percent between 2000 and 2002, while adjusted operating earnings increased 24.6 percent on a 7.9 percent increase in revenue.
Coke and Wal-Mart turned in similar performances. The storied soda company's operating cash flow increased 24.5 percent between 2000 and 2002, while operating earnings rose 26.5 percent on a 12.7 percent increase in revenues. At the discount retailer, operating cash flow rose 31.2 percent during the sample period, while both operating earnings and revenue increased 27.7 percent.
The picture is much different for companies at either the positive or negative end of the ECM scale. Operating cash flow at Sears, Roebuck & Co., which showed the widest positive or negative gap by far, declined by 111.8 percent between 2000 and 2002, and was negative in 2002. During that same period, operating earnings declined only 3.8 percent, while revenue increased a mere 1.3 percent. As a result, the company's ECM fell precipitously during the period, from 3.0 percent in 2000 to -4.2 percent in 2002. The main reason for the company's lack of operating cash flow in 2002 was a significant increase in its credit-card receivables. Not surprisingly, Sears has since sold those receivables to Citigroup and exited the credit-card business.
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