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Quarter 2, 2013
Free Cash Margin Index:
Recession Lows

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

Current

4.63% (Jun. 2013)

Recent High

7.18% (Mar. 2010)

October 2013

In Q2 2013, median free cash margin increased, reaching 4.63% for the twelve months ended June 2013, up from 4.52% and 4.55% for the twelve months ended March 2013 and June 2012, respectively. An increase in profitability in the form of higher operating cushion due to lower SG&A expenses and a reduction in capital spending were the primary drivers of the increase in free cash margin. Over the past two years, free cash margin has now stabilized and is operating within a narrow range.

Of concern, however, is the decline we are seeing in median revenues. Median revenues decreased to $736.85 million, down from $747.23 million for the twelve months ended March 2013 and $753.35 million in the period ending June 2012. The quarterly decline of 1.39% and year-over-year decline of 2.19% signal a slow-down in the U.S. economy. The decline in median revenues accompanied by an increase in free cash margin, driven primarily by a reduction in capital spending, are similar to developments observed during the recession. Whether the economy continues to stumble or begins to regain traction remains to be seen. Certainly recent developments in Washington are not supportive of business confidence and growth.


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August 2013

While elements of other comprehensive income are now afforded prominent display either on the income statement or on a separate statement of comprehensive income, the key focus for measuring financial performance remains with net income. Net income excludes components of other comprehensive income, gains or losses arising from foreign currency translation adjustments, cash flow hedges, available for sale securities and pensions and postretirement benefits. Because net income excludes such gains and losses that are often quite material, evaluations of financial performance based on net income may be misguided.

In this study, we examine the components of other comprehensive income for the firms comprising the S&P 100 over the 2010 to 2012 timeframe. We find that other comprehensive income is more likely to be a loss than again. Companies in our sample reported other comprehensive income losses 60% of the time. We found losses to be predominant in all elements of other comprehensive income and were more than 5% of net income in 38.33% of the cases studied.

These findings should remind analysts and investors that a complete financial analysis should include a careful review of elements of other comprehensive income. For the FASB, the findings indicate that the recent move to require companies to report other comprehensive income either on the income statement or on a separate primary statement of comprehensive income was a step that was much needed in highlighting important elements of financial performance. For CFOs, the study’s findings should provide useful comparisons for benchmarking elements of other comprehensive income against an important sample of companies from among ten industry sectors.


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Quarter 1, 2013
Free Cash Margin Index:
Recession Lows

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

Current

4.52% (Mar. 2013)

Recent High

7.18% (Mar. 2010)

In Q1 2013, median free cash margin declined, reaching 4.52% for the twelve months ended March 2013, down from 4.76% for the twelve months ended December 2012, but up slightly from the 4.46% observed for the twelve months ended March 2012.

Overall, the Q1 2013 data provide us with early signs of a slow-down in the U.S. economy. We are seeing a decline in revenue growth for the first time in seven quarters and declining free cash margin due to declining profitability. Another sign of weakness was a decline in capital spending after eleven consecutive quarters of rising capital expenditures. If these trends continue, we question whether the Federal Reserve should taper its accomodative stance.


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An Analysis Using 2012 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 3.19%. There are 19 industries with a positive Free Cash Profile, and 25 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, 2012
Free Cash Margin Index:
Recession Lows

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

Current

4.76% (Dec. 2012)

Recent High

7.18% (Mar. 2010)

In Q4 2012, median free cash margin increased slightly, reaching 4.76% for the twelve months ended December 2012, up from 4.72% for the twelve months ended September 2012 and 4.54% for the twelve months ended December 2011. Free cash margin appears now to have stabilized at pre-recession levels of between 4.5% and 5.0%. As free cash margin has stabilized, spending patterns have gradually returned to more normal, pre-recession levels, as we observed increased spending on operating expenses, inventories, and capital assets.

Overall, we are not seeing evidence of a slow-down in the U.S. economy. We are seeing robust revenue growth and improving free cash margin even as companies commit significantly more to capital spending. If these trends continue, we should begin to see increased hiring levels giving much-needed relief to our labor markets.


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In this study, using the firms comprising the Dow Jones Industrial Average, we examine the factors that cause effective tax rates to fall either below or above statutory tax rates and current tax rates to fall either below or above effective rates. Contributing to lower rates are the effects of foreign tax rates different from the U.S., tax credits, and adjustments related to prior-year tax accruals, though in some cases, foreign rates are higher than in the U.S. State and local income taxes and interest and penalties had the effect of raising effective tax rates.

Across the 2009 – 2011 sample period we saw an increase in the median effective tax rate, rising to 27.2% in 2011 from 26.7% in 2010 and 24.1% in 2009. It was driven higher primarily by a decline in the tax-rate reduction attributable to lower non-U.S. tax rates. Not all sample companies enjoyed effective tax rates that were below the 35% statutory rate. For example, due to higher tax rates in non-U.S. jurisdictions, the integrated oil companies, Chevron and Exxon-Mobil, had effective tax rates that exceeded 40%. Companies with the majority of their operations in the U.S. reported effective tax rates that were at or above 35%. Firms in this group include Home Depot, United Health Group and Walt Disney Co. Several companies enjoyed effective tax rates below 20%, including Merck and Microsoft, among others, and some profitable companies even reported negative effective tax rates, such as AT&T, Bank of America, Caterpillar and General Electric.

Current tax rates, or taxes that are currently due and payable as a percentage of income before tax, tend to run below effective tax rates. In 2011, the median current tax rate was 24.5%, driven lower than the effective tax rate by deferred taxes arising from the use of accelerated depreciation for income tax purposes. Like the effective tax rate, however, the current tax rate increased across the sample period, rising 24.5% in 2011 from 21.4% in 2010 and 20.7% in 2009. Using the current tax rate as a guide, in 2011 large U.S. multinationals are paying in taxes approximately 25% of income before tax. Many of these large companies have actively sought to reduce their income tax liabilities such that significant components of their profits are earned outside the U.S. where tax rates are lower. As a result, many of the taxes being paid by these companies are going to non-U.S. governments. As tax policy is debated in this country, policy makers would be well advised to take note of the findings of this study. In particular, statutory rates approaching something closer to 25% could be successful in moving back to the U.S. much of the income taxes being paid by companies outside the U.S.


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Quarter 3, 2012
Free Cash Margin Index:
Recession Lows

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

Current

4.72% (Jun. 2012)

Recent High

7.18% (Mar. 2010)

In Q3 2012, median free cash margin increased, reaching 4.72% for the twelve months ended September 2012, up from 4.55% for the twelve months ended June 2012 and 4.41% for the twelve months ended September 2011. Free cash margin appears now to have stabilized at pre-recession levels of between 4.5% and 5.0%. As free cash margin has stabilized, spending patterns have gradually returned to more normal, pre-recession levels, as we observed increased spending on operating expenses, inventories and capital assets.

Growth continues for the U.S. economy and we are observing an ongoing return to normalcy for operating indicators, particularly when compared with pre-recession levels of September 2007. Our data show no obvious evidence of arrested growth as a result of corporate restraint associated with negotiations associated with the so-called fiscal cliff, the debt ceiling or budget sequestration. On the contrary, we saw healthy revenue growth and improving free cash flow even with the increase in spending that is expected in a recovery.


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A noncontrolling interest, also known as a minority interest, exists when a subsidiary is not wholly owned by the parent company. While a careful designation of income and equity attributable to noncontrolling interests is made on the income statement and balance sheet respectively, under GAAP a similar attribution is not made on the statement of cash flows. As such, investors, analysts and other users of financial statements may be unaware that operating cash flow includes amounts attributable to both controlling and noncontrolling interests, potentially leading to over-estimates of cash available for dividends to controlling interests.

In this study, for a sample of firms with significant noncontrollng interests, we examine the amount and placement of distributions to noncontrolling interests on the statement of cash flows. We find that while distribution amounts are significant, averaging 79.2% of income attributable to noncontrolling interests, there is no reporting consistency for the distributions being made. In some instances, distributions are not even disclosed on the statement of cash flows. Recommendations for change to the reporting of distributions to noncontrolling interests on the statement of cash flows are made to make their placement more consistent with the manner in which noncontrolling interest in income is presently reported on the income statement.


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Earnings Quality: Reports on Individual Companies and Industries


In these reports we examine one or more dimensions of earnings quality: the cash flow support of earnings, the sustainability of earnings, or the quality of the balance sheet.

EQI, The Cash Flow Support of Earnings: Industry Review, 01.08.13