Management Accounting

Study: Free-Cash Rise May Signal Start of Economic Turn

But without revenue strength, cost cutting and tough debt collection can only go so far.
David KatzJune 23, 2009

The first year-long improvement in free-cash margin since December 2007 suggests that non-financial public companies “are in the process of turning the corner in terms of financial performance,” according to an upcoming research report on over 3,500 companies by the Georgia Tech Financial Analysis Lab.

For the twelve months ended in March, free cash margin improved to 4.60%, up from the 4.12% reached in December 2008, the current low point in the recession. “This is a particularly striking development in that it is the first twelve-month period since December 2007 that we have seen improvement in free cash margin,” according to the report, which was obtained exclusively by CFO.

Charles Mulford, the Georgia Tech accounting professor who directs the Financial Analysis Lab, says he was stunned by the free cash margin recorded in the survey. In contrast, the figure stood at 2.63% in March 2001.  “That was, by all accounts a mild recession. So here we are in what we’re calling the great recession” and companies are generating more cash for shareholder, he said. “I expected to see much less free cash margin than we did in the last recession.”

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Based on the Lab’s “Free Cash Margin Index” — which looks at companies based on their free cash flow measured as a percentage of revenue for the trailing twelve-month period — the research “provides support for the improvement in stock prices we have seen since early March 2009” as well as the notion that the country may be heading out of the recession, according to the report.

Indeed, the first-quarter percentage was only down slightly from the 4.72% registered during the twelve months ended March, 2008, arguably before the financial crisis hit. During the first three months of this year, in fact, “free cash margin improved even as profitability, as measured by operating cushion, declined,” according to the report, which defines operating cushion as operating profit minus non-cash expenses, depreciation, and amortization.   

Driving the upturn in free cash margin was a small cut in capital spending and a heftier dive in the cash cycle, a working capital metric which the researchers define as “receivables days plus inventory days less payables days is a firm’s cash cycle.”   Firms are truly becoming “lean and mean” and just about keeping pace with a decline in profitability, according to the report. 

The findings come on the heels of several industry studies by CFO of companies in the CFO Midcap 1500 index. Those studies, based on an analysis of data provided by Capital IQ, show that some mid-market companies have managed to hold their own in terms of cash earnings per share, often despite declining sales. As they have in the Georgia Tech data, tougher accounts-receivable efforts as well as cuts in sales, general, and administrative expense seem to have played a part in the CFO results.

By improving their working capital via such steps, some machinery-industry midcaps in the CFO index, for instance, were able to generate enough cash to enable them to keep pace with lost revenue. Similarly, in the software industry, sharp declines in revenue growth were partly offset by declines in SG&A.

Explaining how corporations have managed a boost in free cash flow in the face of the recession, Mulford told CFO that “corporations are just better at managing their operating working capital.” The innovations of just-in-time manufacturing have reduced inventory needs and companies have grown expert in curbing receivables days, he noted.

“They’re just tying up much less cash in working capital, and that’s helped them weather this storm on cash-flow basis,” said Mulford, who is also a principal in Cash Flow Analytics, LLC, which provided some of the research data.

Still, the belt-tightening that generated those results is only half the picture. “It is important to note that while we’re encouraged by the improvement in free cash margin and we’re significantly outperforming where we were, to get any sustainability in free cash flow we have to get improvement in profitability,” Mulford warned.

For the study, the lab conducted a summary review of the cash-flow performance of companies over a series of rolling twelve-month periods from the first quarter of 2000 through the first quarter of 2009. All non-financial public companies in Standard & Poor’s Compustat database with a current market cap of $50 million or more were included, resulting in a total sample of 3,531 companies.

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