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Quarter 2, 2012
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.55% (Jun. 2012)

Recent High

7.18% (Mar. 2010)

In the twelve months ended June 2012, median free cash margin increased, reaching 4.55% from 4.46% reported for the twelve months ended March 2012. Free cash margin has now stabilized at pre-recession levels, and a slight upward bias in the metric is evident. Operating cushion and gross margin improved in this reporting period and spending on capital assets increased slightly, while the cash cycle declined, driven largely by a drop in inventory days. Of particular note is the continuing strength seen in revenue growth. During the twelve months ended June 2012, median revenues reached $753.35 million, which is higher than the pre-recession peak reached in 2008. With growing revenue and improving free cash margin, median free cash flow has also improved markedly, reaching $25.21 million, an amount that is well above pre-recession levels.

During the recent recession, free cash margin improved as companies made significant cuts in spending on SG&A, inventories and capital assets, but now those trends are reversing and spending is returning to more normal levels. As median revenues continue to grow, these factors point to strength in the U.S. economy.


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Quarter 1, 2012
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.46% (Mar. 2012)

Recent High

7.18% (Mar. 2010)

In Q1 2012, median free cash margin  declined for the seventh  time in  eight  quarters, reaching 4.46% for the twelve months ended March  2012,  a marginal decrease of 0.08%  from December 2011.  Free cash margin is declining as companies continue to increase spending on capital assets, SG&A, and on building inventory levels. Moreover, during the current reporting period, median revenues continued to grow.  Hence, there is no evidence in this data of a general slowdown in the U.S. economy.

Looking at individual industries, during the March 2012 reporting  period free cash margin was stable in  25 industries, it increased in 14 and declined in five. Included in this report is a closer look at four separate industries: Beer and Liquor, and Apparel, with increasing free cash margins; and Aircraft and Personal Services, with decreasing free cash margins.

During the recent recession, free cash margin improved as companies made significant cuts in spending on SG&A, inventories and capital assets.  If the slowdown in the U.S. economy continues, we can expect to see a decline in median revenues and a likely improvement in free cash margin as companies close their coffers and resurrect a survival mentality that they began to loosen when the recession ended.


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An Analysis Using 2011 Data

As the US economy continues its slow recovery, companies are once again enjoying renewed, if limited, revenue growth. In terms of cash flow generation, as revenues grow, there are certain industries and companies that will benefit more than others. It is a common misbelief that growth requires a use of cash. The reality is that there are many companies that actually generate increasing amounts of free cash flow as revenues grow. These companies have what we refer to as a positive the Free Cash Profile.

The purpose of this study is to analyze the Free Cash Profile of 44 non-financial industries, looking at all firms within those industries that have revenues in excess of $100 million. Our goal is to identify those industries that should generate cash as revenues continue to grow, as well as those industries that will consume cash with growth. We also highlight specific industries to investigate factors underlying the Free Cash Profile.

Overall, the median Free Cash Profile for our sample is 3.73%. There are 24 industries with a positive Free Cash Profile, and 20 industries with a negative Free Cash Profile—though even in these industries, there will be numerous firms with positive profiles. Industries with positive Free Cash Profiles enjoy higher operating cushions and are more adept at managing operating working capital and limiting capital spending than industries with negative Profiles.


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Quarter 4, 2011
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.54% (Dec. 2011)

Recent High

7.18% (Mar. 2010)

After six straight quarters of declines, median free cash margin increased, reaching 4.54% for the twelve months ended December 2011, up 0.13% from 4.41% in September 2011. However, in contrast with increases in free cash margin witnessed during the recession, which were driven by reductions in inventories and capital expenditures, free cash margin is now growing in spite of increases in inventories and capital expenditures. In effect, revenue growth is enabling companies to increase spending without negatively impacting their generation of free cash flow.

While operating cushion was marginally lower during the twelve months ended December 2011, dropping to 15.89% from 16.02% noted during the twelve months ended September 2011, the cash cycle declined, dropping to 49.09 days in December 2011 from 50.10 days in September. The decline in the cash cycle occurred despite an increase in inventory days, driven lower primarily by a decline in accounts receivable days to 50.32 days in December 2011 from 51.99 days in September. Capital expenditures increased to 3.41% in the twelve months ended December 2011, up from 3.29% in September. Taken collectively, the net effect of a slightly lower operating cushion, a lower cash cycle and higher capital spending, was an increase in free cash margin.

Looking at individual industries, during the December 2011 reporting period, free cash margin was stable in 31 industries, it increased in three industries and declined in ten. Included in this report is a closer look at four separate industries, two with increasing free cash margin, defense and fabricated products, and two with declining free cash margin, construction materials and coal.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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The Cash Flow Classification of Premiums on Life Insurance Policies

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Quarter 3, 2011
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.41% (Sep. 2011)

Recent High

7.18% (Mar. 2010)

After six straight quarters of declines, median free cash margin increased, reaching 4.54% for the twelve months ended December 2011, up 0.13% from 4.41% in September 2011. However, in contrast with increases in free cash margin witnessed during the recession, which were driven by reductions in inventories and capital expenditures, free cash margin is now growing in spite of increases in inventories and capital expenditures. In effect, revenue growth is enabling companies to increase spending without negatively impacting their generation of free cash flow.

While operating cushion was marginally lower during the twelve months ended December 2011, dropping to 15.89% from 16.02% noted during the twelve months ended September 2011, the cash cycle declined, dropping to 49.09 days in December 2011 from 50.10 days in September. The decline in the cash cycle occurred despite an increase in inventory days, driven lower primarily by a decline in accounts receivable days to 50.32 days in December 2011 from 51.99 days in September. Capital expenditures increased to 3.41% in the twelve months ended December 2011, up from 3.29% in September. Taken collectively, the net effect of a slightly lower operating cushion, a lower cash cycle and higher capital spending, was an increase in free cash margin.

Looking at individual industries, during the December 2011 reporting period, free cash margin was stable in 31 industries, it increased in three industries and declined in ten. Included in this report is a closer look at four separate industries, two with increasing free cash margin, defense and fabricated products, and two with declining free cash margin, construction materials and coal.


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Cash Flow Trends and Their Fundamental Drivers:Comprehensive Review (Quarter 1, 2012)

FREE CASH MARGIN INDEX: