More companies are tying incentive pay to performance in an up-and-coming metric: free-cash flow (FCF). Bausch & Lomb, Motorola, Kraft Foods, and American Standard are among those that are linking pay to cash available after operating activities.
Proponents say it is a better indicator of overall company performance and less easy to manipulate than net income. “The problem is that it is so easy to manage earnings,” says Charles Mulford, director of the Georgia Tech Financial Analysis Lab. Techniques such as channel stuffing, selling off investments, and tapping into reserves, he adds, can’t manipulate FCF as easily.
The metric is also more controllable than share price. “Sometimes the share price is really outside management’s control,” says Mulford. “They feel that they are at the mercy of the whims of the market.”
FCF is calculated by adding depreciation and amortization back to net income, subtracting the net change in working capital, and then subtracting capital expenditures. More simply, it is found by subtracting capital expenditures from cash flow from operations. FCF is the cash available after operating activities to pay down debt, issue dividends, buy back stock, or invest.
American Standard Co., a Piscataway, N.J.-based manufacturer of kitchen and bath fixtures, added FCF to its list of incentive-pay measures when it intensified its campaign to pay down debt. “It has worked extremely well,” says Noreen Farrell, director of corporate compensation. The company has reduced debt by nearly $1 billion since it started using the measure in 2000. In addition to FCF, American Standard ties compensation to sales growth, gross margin, and net income. The four metrics make up 70 percent of the incentive; 30 percent is decided by nonfinancial measures.
FCF is not infallible, however. Managers can game it by delaying vendor payments or securitizing receivables — two activities Mulford advises companies to watch out for.