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Financial Analysis Lab

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March 2016

In this study, we review reconciliations between GAAP and non-GAAP net income in order to determine the nature and impact of the adjustments that companies are making to GAAP income to derive non-GAAP income. Our sample consists of the firms in the S&P 100 and their reporting of GAAP and non-GAAP net income for fiscal year 2013.

Seventy-five of the 100 S&P firms report some measure of non-GAAP income for 2013. A total of 74.7% of the sample report non-GAAP income figures that exceed their GAAP earnings. For the sample, median non-GAAP income is 111.21% of GAAP income.In terms of adjustment frequency, income tax items occur most frequently, followed by adjustments for restructuring and productivity related charges, impairment charges and litigation expenses. Adjustments for non-cash compensation, while not the most frequently employed adjustment, did have the greatest effect in altering GAAP income, raising non-GAAP income by the median value of 13.75%.


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An Analysis Using Data from June 2000 through May 2015

February 2016

In this study we examine capital spending for the period June 2000 (referred to as 2000) through May 2015 (referred to as 2014) for U.S. non-financial firms with total revenues exceeding $100 million. We find that capital spending was curtailed significantly during the recession, falling to 3.43% of revenue in 2009 from 4.25% in 2008. With the metric reading 4.50% in 2014, spending has recovered to pre-recession levels. However, companies have not taken steps to increase capital spending to make up for the recession-induced decline. We estimate the cumulative amount of capital expenditures effectively lost to the recession to be $296.5 billion.

Using a series of graphs we examine the level of capital spending, the cash flow capacity for capital spending, the extent of capital asset replacement, the mix of assets on corporate balance sheets and alternatives to capital expenditures.

The results are presented in a series of graphs. These graphs depict the findings for the overall sample of non-financials and for each of nine sectors. Tabular results are presented in an appendix.


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Quarter 4, 2015
Free Cash Margin Index:
Recession Lows

1.75%, 4.21% (Dec. 2000, Dec. 2008)

Current

5.41% (Dec. 2015)

Recent High

7.68% (Dec. 2009)

May 2016

Median free cash margin increased to 5.41% for the twelve months ended December 2015, up from 5.00% for the twelve months ended September 2015 and from 4.55% in December 2014. The metric climbed to the high end of its historical range of between 4.50% and 5.50%. A decrease in the overall cash cycle (due to a decrease in accounts receivable days) continues to be the primary driver of the increase. Operating cushion, or operating profit before depreciation, declined modestly to 15.05% from 15.53% in December 2014, driven by a decline in gross margin and an increase in selling, general and administrative expense as a percent of revenue. Capital expenditures to revenue were unchanged at 3.29%.

Continued meager topline growth suggests an economy that is growing, but struggling to grow. Median revenues within our sample increased to $630.83 million, up from $620.91 million for the twelve months ended December 2014 and $616.49 million for the twelve months ended September 2015.

Overall, accounting data for the twelve months ending with the fourth quarter of 2015 continue to show signs of weakness to recent trends of a steadily growing economy.Looking at individual industry groups for the reporting period ending December 2015, free cash margin was higher in nine industry groups, stable in four, and lower in seven.

Data for this research were provided by S&P Capital IQ’s Compustat database..


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Accounting Practices in the Software Industry, 2014 and 2015

January 2016

For software companies, all software development costs incurred prior to technological feasibility are expensed as R&D. Once technological feasibility is reached software development costs are capitalized up to the point of completion and product release. At this point, amortization of capitalized costs begins.

Determining technological feasibility and the timing of software development completion entails management judgment, creating flexibility in capitalization policies. Given this flexibility, it can be difficult to compare financial results across firms in the software industry. The purpose of this study is to survey policies for software development capitalization during 2014 and 2015 (fiscal years ending between July 1, 2014 and June 30, 2015). The results are then compared with similar studies conducted in 2006 and 2010.

Overall, 61% of the software companies in the sample expensed all software costs incurred. Of the remaining 39% that capitalized costs, the average percentage of software costs incurred that were capitalized was 18.1%. These results show a small shift from the 2006 and 2010 studies where approximately 70% of the sample expensed all software costs incurred. In addition, in the 2006 and 2010 studies, the companies that capitalized software costs had an average rate of capitalization of 20% and 15%, respectively.


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Quarter 2, 2015
Free Cash Margin Index:
Recession Lows

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

Current

4.65% (Jun. 2015)

Recent High

7.18% (Mar. 2010)

October 2015

Median free cash margin increased to 4.65% for the twelve months ended June 2015, up from 4.39% for the twelve months ended March 2015 and from 3.97% in June 2014. The metric remains in the middle range of its historical stability between 4.00% and 5.00%. A decrease in the overall cash cycle (due to a decrease in accounts receivable days) continues to be the primary driver of the increase, while a modest increase in gross margin was observed for the period, up to 43.52% from 43.06% in March 2015 and 42.80% in June 2014. Capital expenditures to revenue decreased ever so slightly to 3.50% from the previous quarter at 3.52%.

Continued topline growth suggests a strengthening economy. Median revenues within our sample increased to $806.20 million, up from $789.15 million for the twelve months ended March 2015 and from $739.70 for the twelve months ended June 2014. Median revenues remain at all-time high levels and hover above the previous peak of $788.50 million reached during the period ending December 2012.

The rise in free cash margin would be more substantial but for the decline in accounts payable, the primary drag on free cash margin. Inventory reversed its slight upward trend for the first time in six periods, down slightly to 22.22 revenue days from 22.78 revenue days in March 2015. SG&A expenses have risen slowly to 21.43% in June 2015, up from 21.34% in March 2015 and 21.11% in June 2014. Overall, accounting data for the twelve months ending with the second quarter of 2015 imply a steadily growing economy.

Looking at individual industries for the reporting period ending June 2015, free cash margin was higher in twenty industries, stable in fifteen, and lower in nine.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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September 2015

In this study, we examine the treatment of percentage of completion accounting (POC) for financial reporting purposes within the aerospace and defense industry, an industry that utilizes POC accounting extensively. POC accounting addresses revenue recognition practices for long-term contracts. In applying POC accounting, companies recognize revenues primarily by comparing costs incurred to total estimated costs to complete the contract. Because estimates are used, unexpected cost overruns can lead to significant losses late in a contact’s life. Under the POC method, customer billings and cash flow can also proceed at rates that are significantly at odds with the timing of revenue recognition. For many firms, the unique risks associated with POC accounting lead them to list POC accounting as an explicit risk factor of which readers of their financial statements should be cognizant. With examples, the paper details how the POC method of revenue recognition is applied. Requirements from the new revenue recognition standard contained in Accounting Standards Codification 606, Revenue Recognition, are provided along with a summary of the changes that can be expected as companies move to adopt the new standard.

Presently, we find disclosures related to POC accounting to be lacking. In the aerospace and defense industry only seven companies, or 44% of the 16 firms in the sample, disclose the percentage of revenues derived from POC accounting. Approximately half of the sample report the amount of progress payments made on contracts, while nine disclose whether the company is in an over-billed or under-billed position. Finally, only five companies provide information on the timing of revenue recognition versus cash receipt. Nine companies list POC accounting as an explicit risk factor.

For analysts and investors, our findings demonstrate that given the lack of disclosure, care must be taken with the financial statements of companies who use the POC method extensively. For CFOs, the results highlight the changes that will need to be made to their companies’ financial statements in upcoming years to comply with new revenue recognition standards. For regulators and accounting standards setters, the results highlight the shortcomings of current accounting and disclosure practices for long-term contracts and the improvements that can be expected as companies move to adopt the new revenue recognition standard.


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Quarter 1, 2015
Free Cash Margin Index:
Recession Lows

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

Current

4.39% (Mar. 2015)

Recent High

7.18% (Mar. 2010)

July 2015

Median free cash margin increased to 4.39% for the twelve months ended March 2015, up from 4.27% for the twelve months ended December 2014 and from 4.38% in March 2014. The metric remains in the middle range of its historical stability between 4.00% and 5.00%. A decrease in the overall cash cycle (due to a decrease in accounts receivables days) was the primary driver of the increase.

Continued topline growth suggests a strengthening economy. Median revenues within our sample increased to $789.15 million, down slightly from $798.78 million for the twelve months ended December 2014 and up 8.8% from $725.47 for the twelve months ended March 2014. Median revenues remain near all-time high levels and hover above the previous peak of $788.50 million reached during the period ending December 2012.

The rise in free cash margin would be more substantial but for the decline in accounts payable, the primary drag on free cash margin comparative to recent periods. Inventory is up slightly at 22.78 revenue days from 22.71 revenue days in December 2014, while gross margin is down slightly to 43.06% from 43.16%. Capital expenditures to revenue increased ever so slightly to 3.52% from the previous quarter at 3.51%. Overall, accounting data for the twelve months ending with the first quarter of 2015 imply an economy that is improving, but in measured steps.

Looking at individual industries for the reporting period ending March 2015, free cash margin was stable in fifteen industries, higher in eighteen, and lower in eleven.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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An Analysis Using 2014 Data

May 2015

As the U.S. 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 here as a positive 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 can be expected to 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 their free cash profile.

Overall, the median free cash profile for our sample is 2.22%, below the median profile of 3.35% observed in 2013. A decline in operating cushion, an increase in working capital needs and an increase in capital expenditures all contributed to the drop in free cash profile. There are 20 industries with a positive free cash profile, and 24 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.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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Quarter 4, 2014
Free Cash Margin Index:
Recession Lows

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

Current

4.27% (Dec. 2014)

Recent High

7.18% (Mar. 2010)

April 2015

Median free cash margin increased to 4.27% for the twelve months ended December 2014, from 4.01% for the twelve months ended September 2014, but down from 4.56% in December 2013. The metric has now increased into the middle range of its historical stability between 4.00% and 5.00%. A decrease in the overall cash cycle (due to a decrease in accounts receivables days) and an increase in gross margin percent were the primary drivers of the increase.

Continued topline growth suggests an improving economy. Median revenues within our sample increased to $798.78 million, up from $774.50 million for the twelve months ended September 2014. Median revenues are now at an all-time high, comfortably surpassing their peak of $788.50 million reached during the period ending December 2012.

The rise in free cash margin would be more substantial but for the decline in accounts payable, the primary drag on free cash margin compared with recent periods. Inventory is up slightly at 22.71 revenue days from 22.52 revenue days in September 2014. Inventory investment coupled with increased gross margin percentage signal an improving economy. Capital expenditures to revenue increased to 3.51% from the previous quarter at 3.47%. Capital expenditures by this measure is at 95.90% of its five year high of 3.66%. Overall, accounting data for the twelve months ending with the fourth quarter of 2014 imply a strong and growing economy.

Looking at individual industries for the reporting period ending December 2014, free cash margin was stable in sixteen industries, higher in thirteen, and lower in fifteen.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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Quarter 3, 2014
Earnings Quality Indicator:
Pre-Recession

4.55% (Jun. 2007)

Current

4.84% (Sep. 2014)

Recent High

8.58% (Dec. 2009)

March 2015

During the recent financial crisis, median earnings quality, measured using EQI or operating cash margin less net margin, has increased dramatically and then fallen to pre-recession levels. In a January 2013 Report, the Georgia Tech Financial Analysis Lab noted the return of EQI to normal levels. Today, we revisit earnings quality trends by observing the median EQI for 44 non-financial industries. Median EQI for all non-financial industries rose slightly from 4.56% for the twelve months ending June 2012 to 4.84% for the twelve months ending September 2014.

This 6.14% rise in EQI demonstrates stabilization of earnings quality trends around normal levels. Companies found an equilibrium ratio of operating cash flow to revenue as the effects of reducing inventories and of taking longer to collect payment of operating receivables offset. However, net margins suffered as operating cushion percent was reduced by weaker gross margins. Companies may continue to see gross margin reversion from recent highs as labor seeks greater claims on revenue and new entrants fueled by easy credit are able to enter markets.

A falling EQI raises questions about the sustainability of future earnings. In a similar fashion, a rising EQI raises questions about the sustainability of future operating cash flow. A stable EQI, showing no discernible trend, is one that does not raise such questions about the sustainability of future earnings or operating cash flow. While EQI did show a significant increase during the recession and a decline after the recession ended, EQI has stabilized at a level that existed prior to the recent recession. In future periods we expect EQI to trend around current levels. Significant increases or declines from this level could be cause for concern.

Regarding individual industries, during the period between June 2012 and September 2014, EQI was stable in 17 industries, increased in 13 and declined in 14. In this report we take a closer look at one individual industry where EQI has risen dramatically, Aircraft.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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The Effects of Tax Reform on Deferred Taxes: The Winners and Losers

February 2015

In this study, we examine the impact of US corporate income tax reform on deferred taxes. Our objective is to identify those companies and industries that stand to gain and those that stand to lose from a potential decrease in the U.S. corporate tax rate. 

Deferred tax assets are the tax savings arising from future tax deductions. Deferred tax liabilities reflect taxes due on future taxable amounts. Both deferred tax assets and deferred tax liabilities are measured using tax rates expected to be in effect when underlying deductions or taxable amounts are realized. A reduction in the corporate tax rate, expected with tax reform, would reduce reported deferred tax assets and liabilities, resulting in decreases in assets and shareholders’ equity for some firms and decreases in liabilities with increases in shareholders’ equity for others. For a sample of 809 U.S. companies with reported deferred tax balances, we present the financial statement effects of lowering the corporate income tax rate from 35% to 28%. 

Overall, we find that 548 sample companies with deferred tax liabilities will enjoy a $142.4 billion reduction in liabilities and increase in shareholders’ equity. Industries impacted the most include the utilities, oil and gas and transportation firms. In contrast, we find that 261 sample firms with deferred tax assets will see assets and shareholders’ equity decline by $38.2 billion. On this score, the Financials is the industry that is affected the most. 

Equity and credit analysts, investors and creditors will want to evaluate the effects of tax reform on the financial position of portfolio companies. Corporate managers will want to gauge the potential effects of tax reform on their firms’ assets, liabilities and shareholders’ equity and evaluate those effects on existing debt covenants.


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Quarter 3, 2014
Free Cash Margin Index:
Recession Lows

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

Current

4.01% (Sep. 2014)

Recent High

7.18% (Mar. 2010)

January 2015

In Q3 2014, median free cash margin increased slightly to 4.01% for the twelve months ended September 2014, from 3.97% for the twelve months ended June 2014, but down from 4.68% in September 2013. The metric is now at the low end of its historical range for stability between 4.00% and 5.00%. A decrease in the overall cash cycle, driven by a decrease in receivables days and an increase in payables days, was the primary driver of the increase.
Although modest, the growth in revenues within the sample suggests the economy continues to move in the right direction. Median revenues within our sample increased to $774.50 million, up from $739.70 million for the twelve months ended June 2014. Median revenues are at 98.2% of their peak of $788.50 million during the period ending December 2012. The slight rise in free cash margin would have been more substantial but for inventory investments, the primary drag on free cash margin comparative to the twelve months ended June 2014. Inventory is up slightly since last quarter and is now at 22.52 revenue days, although it is down from a year prior of 23.74 revenue days. Inventory investment coupled with stable gross margin percentage can signal an improving economy, but the changes may be too slight to be conclusive in this case. Capital expenditures to revenue held steady from the previous quarter at 3.47%, off from one year ago at 3.50% and 94.8% of its five year high of 3.66%. Weak capital expenditures do not signal a strengthening U.S. economy but rather management uncertainty, especially in light of the current low interest rate environment. Companies have continued to resist using the Fed’s easy money policies to invest for growth. Overall, accounting data for the twelve months ending with the third quarter of 2014 does not imply a strong and strengthening economy.

Looking at individual industries for the reporting period ending September 2014, free cash margin was stable in twenty-two industries, higher in nine, and lower in thirteen.

Data for this research were provided by Cash Flow Analytics, LLC., www.cashflowanalytics.com.
Charles Mulford is a principal in Cash Flow Analytics, LLC.


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