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A new study of operating cash flow and earnings for the 87 nonfinancial companies in the Standard and Poor's 100 suggests that the recent upturn in corporate profits may not be sustainable.
Ronald Fink, CFO Magazine
December 1, 2003
Is 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.
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.
Results at other companies whose operating cash flow showed a marked decline in relation to income during the period, including The Walt Disney Co., PepsiCo, and United Technologies, reflected weak revenue growth, increases in working capital, or outsize pension contributions.
At the other end of the spectrum were companies like H.J. Heinz, Amgen, Hewlett-Packard, and Microsoft, all of whose 2002 ECM exceeded their average differential for the three-year period by at least 145 percent. At Hewlett-Packard, for instance, operating cash flow grew by 158.1 percent over the sample period and outpaced by a wide margin its 50 percent decrease in operating earnings, while revenue advanced 15.8 percent. That sent HP's ECM up from -2.3 percent in 2000 to 7.5 percent in 2002. The underlying cause: liquidations of accounts receivables, financing receivables, and inventory. Depreciation and amortization, which also played a role, were 54.8 percent higher in 2002 than in 2001.
Interpreting ECM can be challenging. A cyclical company may generate more operating cash flow than operating earnings during a business slowdown as assets and liabilities are liquidated. When business picks up and liquidated accounts are replenished, earnings may grow at a rate faster than operating cash flow. In that case, the two measures are likely to return to relative balance before long.
On the other hand, excessive ECM at any given point may instead reflect a change in the stage of a company's life cycle, as the transition from growth to maturity or from maturity to decline alters the relationship between earnings and operating cash flow for good.
Regardless of whether changes in ECM reflect business or life cycles, however, the measure does appear to provide a valuable snapshot of a company's ongoing operating performance. And in the current environment, no issue is more critical to building and retaining shareholder value than the degree to which a company's underlying business is or is not expanding.
Ronald Fink is a deputy editor of CFO.
Studying the Flow
To produce its findings, the Financial Analysis Lab at Georgia Institute of Technology's DuPree College of Management adjusts both operating cash flow and net income for one-time, nonoperating items. But Dupree's adjustments to cash flow are more extensive than those to income.
The latter are limited largely to items related to mergers, restructurings, and litigation, as those are among the chief isolated events affecting income that can be readily identified in a company's financial statements.
In contrast, it is possible to identify many more nonrecurring, nonoperating items on a company's cash-flow statement, ranging from obvious events, such as the securitization of receivables and income or losses from discontinued operations, to more obscure items, such as bank overdrafts and tax benefits related to stock-option grants.
|Percentage change in operating cash flow|
resulting from adjustments for 2002
|Company||2002 Operating Cash Flow — Reported|
|2002 Operating Cash Flow — Adjusted|
|2002 Percentage Difference|
|1. Lucent Technologies||$(756)||$791||204.6%|
|3. Sears, Roebuck||(505)||(319)||36.9|
|4. Norfolk Southern||803||1,085||35.1|
|5. Ford Motor||18,633||24,956||33.9|
|6. El Paso||436||551||26.4|
|7. Honeywell International||2,380||2,843||19.5|
|11. International Paper||2,094||2,343||11.9|
|12. Altria Group||10,612||11,784||11.0|
|14. Bristol-Myers Squibb||957||1,048||9.5|
|16. U.S. Bancorp||3,786||4,113||8.6|
|17. Eastman Kodak||2,204||2,380||8.0|
|19. American Electric||1,677||1,789||6.7|
|20. Procter and Gamble||7,742||8,240||6.4|
|21. Minnesota Mining and Manufacturing||2,992||3,179||6.2|
|24. Black & Decker||452||472||4.4|
|26. J.P. Morgan Chase & Co.||(25,134)||(24,212)||3.7|
|28. Dow Chemical||2,108||2,178||3.3|
|29. Merrill Lynch||19,442||20,053||3.1|
|31. Burlington Northern Santa Fe||2,106||2,164||2.7|
|32. Boise Cascade||308||316||2.5|
|33. Baxter International||1,193||1,222||2.5|
|34. Allegheny Technologies||204||209||2.5|
|36. Bank of America||(12,007)||(11,775)||1.9|
|37. Sara Lee||1,735||1,767||1.8|
|38. SBC Communications||15,210||15,471||1.7|
|39. Texas Instruments||1,992||2,023||1.6|
|40. May Department Stores||1,460||1,481||1.5|
|41. United Technologies||2,853||2,893||1.4|
|42. Cisco Systems||6,587||6,659||1.1|
|43. General Electric||29,488||29,778||1.0|
|45. Avon Products||565||569||0.8|
|46. Computer Sciences||1,148||1,155||0.6|
|47. H.J. Heinz||891||896||0.6|
|48. American International||18,688||18,793||0.6|
|49. Wells Fargo||(13,978)||(13,908)||0.5|
|50. General Motors||17,109||17,195||0.5|
|51. Bank One||5,438||5,460||0.4|
|52. Campbell Soup||1,017||1,021||0.4|
|53. Verizon Communications||22,100||22,132||0.1|
|54. Clear Channel Communications||1,748||1,750||0.1|
|55. General Dynamics||1,125||1,126||0.1|
|56. The Goldman Sachs Group||(10,077)||(10,077)||0|
|57. Toys "R" Us||574||574||0|
|58. Rockwell International||476||476||0|
|59. The Limited||795||795||0|
|63. Walt Disney||2,286||2,276||-0.4|
|64. Hartford Financial||2,649||2,630||-0.7|
|67. Johnson & Johnson||8,176||8,113||-0.8|
|68. Home Depot||4,802||4,764||-0.8|
|72. The Southern Co.||2,831||2,794||-1.3|
|73. Wal-Mart Stores||12,532||12,369||-1.3|
|74. Lehman Brothers||24,459||24,112||-1.4|
|75. Nextel Communications||2,523||2,486||-1.5|
|79. AOL Time Warner||7,032||6,816||-3.1|
|80. Harrah's Entertainment||739||713||-3.6|
|82. Morgan Stanley Dean Witter||(5,054)||(5,301)||-4.9|
|88. National Semiconductor||100||89||-11.4|
|91. Baker Hughes||677||586||-13.4|
|95. American Express||8,674||6,863||-20.9|
|99. Delta Air Lines||285||160||-43.9|
|100. The Williams Cos.||(542)||(828)||-52.8|
|Source: DuPree College of Management,|
Georgia Institute of Technology
The ECM Scale
Excess cash margin (ECM) = (adjusted cash provided by operating activities - adjusted income from continuing operations) / revenue, expressed in percent.
|Excess Cash Margin for the S&P 100 Nonfinancials,|
|Company||2000 ECM in %||2001 EMC in %||2002 EMC in %||3-Year Mean ECM||% 2002 Above or Below Mean|
|1. Sears, Roebuck||3.0||2.4||-4.2||0.4||-1188.59|
|3. Bristol-Myers Squibb||2.1||15.3||-9.5||2.6||-467.39|
|5. General Dynamics||1.3||1.1||-0.1||0.8||-108.91|
|8. Johnson & Johnson||8.5||14.6||3.3||8.8||-62.91|
|9. Walt Disney||11.8||8.4||4.2||8.1||-48.47|
|10. The Williams Cos.||-25.7||14.6||3.3||8.8||-62.91|
|12. The Limited||4.5||8.0||3.2||5.2||-38.42|
|13. Clear Channel Communications||23.0||22.5||12.2||19.2||-36.77|
|14. United Technologies||2.6||2.7||1.6||2.3||-30.56|
|16. Harrah's Entertainment||12.4||14.5||9.3||12.1||-23.23|
|17. Boise Cascade||4.8||5.5||3.7||4.6||-20.31|
|18. International Paper||9.1||8.1||6.3||7.8||-19.52|
|19. Avon Products||-3.0||3.8||0.3||0.4||-11.81|
|20. Ford Motor||14.3||14.2||12.2||13.6||-9.84|
|22. General Motors||9.9||6.4||7.0||7.8||-9.55|
|23. Delta Air Lines||13.0||4.0||7.4||8.1||-9.05|
|24. Computer Sciences||4.6||9.1||6.3||6.7||-5.72|
|25. Norfolk Southern||15.1||6.9||10.4||10.8||-3.76|
|26. Nextel Communications||23.4||32.1||26.7||27.4||-2.59|
|27. General Electric||10.6||12.9||11.5||11.7||-1.62|
|30. Home Depot||0.4||3.3||1.9||1.8||2.55|
|32. Burlington Northern Santa Fe||14.1||15.3||15.6||15.0||4.05|
|34. Minnesota Mining and Manufacturing||3.3||8.9||6.6||6.3||5.36|
|35. Wal-Mart Stores||1.6||1.6||1.8||1.7||6.05|
|36. The Southern Co.||13.5||12.1||14.0||13.2||6.10|
|37. Baxter International||0.3||1.0||0.7||0.7||6.75|
|38. Rockwell International||7.0||4.4||6.3||5.9||6.85|
|41. Verizon Communications||12.0||22.5||19.9||18.1||9.95|
|43. Campbell Soup||6.9||6.7||8.1||7.2||11.50|
|44. Texas Instruments||7.4||23.4||18.3||16.4||11.64|
|46. American Express||15.0||13.4||17.4||15.3||14.20|
|47. Altria Group||3.8||0.3||2.5||2.2||14.39|
|48. SBC Communications||16.3||14.9||19.4||16.9||14.82|
|52. May Department Stores||3.3||6.5||6.4||5.4||18.61|
|53. Baker Hughes||7.9||3.9||7.8||6.5||19.72|
|55. Black & Decker||1.5||5.1||4.7||3.8||24.75|
|56. Exxon Mobil||3.3||3.4||4.8||3.8||25.07|
|58. AT & T||3.3||21.7||19.8||14.9||32.62|
|61. Sara Lee||1.3||3.1||3.6||2.7||35.71|
|62. Tyco International||8.2||6.7||12.7||9.2||38.28|
|63. Dow Chemical||1.3||6.8||7.1||5.1||39.84|
|65. National Semiconductor||3.1||11.2||12.9||9.1||41.99|
|66. Honeywell International||0.9||4.1||4.8||3.3||47.67|
|68. Cisco Systems||4.8||18.6||23.2||15.5||49.39|
|70. Procter and Gamble||2.0||5.0||8.2||5.1||61.49|
|72. Eastman Kodak||-2.3||11.6||11.7||7.0||67.06|
|76. El Paso||-0.4||6.4||9.7||5.2||84.96|
|77. American Electric Power||-6.0||9.5||7.0||3.5||99.76|
|78. Toys "R" Us||-2.1||3.5||3.1||1.5||104.99|
|81. AOL Time Warner||-2.1||16.2||49.4||21.1||133.53|
|82. Lucent Technologies||-7.5||31.0||87.7||37.1||136.56|
|83. Allegheny Technologies||0.2||2.9||11.7||4.9||137.34|
|87. H.J. Heinz||-0.8||-2.3||0.5||-0.9||161.66|
|Source: DuPree College of Management,|
Georgia Institute of Technology