Management Accounting

What Slowing Economy? Free Cash Margins Say Otherwise

Some U.S. companies have lower free cash flow these days, but it&spamp;rsquo;s for a good reason.
Kathy HoffelderAugust 9, 2012

A measure of free cash flow shows that U.S. companies had less cash available to pay dividends, buy back stock, or just facilitate growth in the first quarter. But that wasn’t necessarily a bad thing, as their levels were lower because they increased their spending on capital assets; selling, general, and administrative expenses (SG&A); and inventory buildups, all potential positive signs for the U.S. economy.

Median free cash margin, or the average free cash flow taken as a percentage of revenue, declined for the seventh time in eight quarters for these companies, reaching 4.46% at the end of the first quarter. That was down from 4.54% in December 2011, according to a report studying more than 2,900 U.S. companies in 44 industries from Charles W. Mulford, an accounting professor at Georgia Tech University and director of the Georgia Tech Financial Reporting & Analysis Lab.

While free cash margin was declining, Mulford says, spending increased on SG&A, rising to 21.3% in the first quarter from 19.84% at the close of 2011. Companies also marginally increased their capital expenditures, to 3.50% from 3.41%.

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“These are discretionary expenditures that managers have shown they are willing to cut if business were to slow significantly,” says Mulford. “The fact that spending on these items is growing is testament to the continued resilience of the U.S. economy.” He bases his findings on data from Cash Flow Analytics.

Changes in the cash cycle, the time between when a company gets paid and when it puts that cash to work, also contributed to the decrease in free cash margin. While having a shorter cash cycle is more ideal for businesses, in Mulford’s study on average companies’ cash cycles rose slightly in the first quarter, to 49.98 days from 49.09 days the quarter before. Similarly, the average number of days a U.S. company held inventory rose marginally, to 24.69 from 24.62.

Longer cash cycles plagued the personal-services industry, which includes everything from accounting firms and funeral and daycare services to lawn-maintenance businesses. The cash cycle for this sector increased during the first quarter by 10 days, to 17.78 days from 7.19 days, while free cash margin fell from 7.69% at the end of the fourth quarter of 2011 to 6.20% in the first quarter of this year, according to Mulford. These businesses’ average operating cushion, or profit from operations, also declined, to 16.31% in the first quarter from 19.57% the prior quarter.

Other sectors that had a drop in free cash margin in the first quarter of 2012 included agriculture, candy and soda, consumer goods, rubber and plastics, shipping containers, transportation, utilities, petroleum and natural gas, coal, metal mining, aircraft, machinery, and construction.

In contrast, companies in the beer and liquor, apparel, medical-equipment, steel, shipbuilding, and railroad-equipment industries all increased their free cash margin.