Prompted by the slightest of upticks in revenue, companies have begun to increase their capital spending and add to their inventories, a new study shows.
At the same time, companies’ free cash margins — which measure the free cash flow available for shareholders that can be used for buybacks, dividends, and other purposes — continue to narrow, the Georgia Tech Financial Analysis Lab reported.
While median revenues rose a mere 0.56% from the 12 months ending in December 2010 to the 12 months ending in March 2011, from $548 million to $551 million, median free cash flow dropped 11.3% over the same period, from $23 million to $21 million.
But the drop in free cash flow could prove to be more of a help than a hindrance to the struggling economy, according to Charles Mulford, a Georgia Tech Accounting professor who runs the lab. “It’s showing that companies are starting to spend, and that’s what we need if we’re going to pull out of the postrecession doldrums,” he says of the decrease.
Helping to drive free cash flow down were increased costs associated with capital expenditures and inventory. Capex rose from 2.9% of revenue in the year ending December 2010 to 3.01% in the year ending March 2010, according to the study, which looked at 3,126 companies with market caps of at least $50 million.
Further, companies seem to be starting to put a few more items in their supply chains. Inventory days increased to 23 days in the March 2011 reporting period from 22 days in the December 2010 period. The lab defines inventory days as inventory (including capitalized interest) divided by revenue from core operations measured on a daily basis, using a 365-day year.
The combination of those factors has resulted in a decline in free cash margin (free cash flow divided by revenue) one of Mulford’s pet metrics. Median free cash margin declined for the fourth straight quarter off of its March 2010 high of 7.18%, according to the study. Free cash margin fell 5.20% for March 2011, below the 5.56% reported in December 2010, though higher than any period before June 2009.
Mulford says he is encouraged by the decline in free cash margin, “and I never thought I’d say that.” When the recession hit, he expected companies to struggle to achieve adequate levels of free cash flow. But what actually happened was that companies registered big improvements in free cash flow as a result of gingerly managed inventory and capital spending.
Such careful hoarding of cash, however, would only weaken what’s already a weak economic recovery, according to the professor. “To really pull out, I think we need to see something that is the opposite of that,” Mulford says.