The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants.
Because our lab is housed within a university, our research reports are designed to impart knowledge and understanding to the reader. We focus on issues we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or large segments of the market at large.
A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times, our research may look at stock prices generally, though from a fundamental and not technical point of view.
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| 2019 |
Cash Flow Trends and Their Fundamental Drivers: Comprehensive Review
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| 2018 |
Cash Flow Trends and Their Fundamental Drivers: Comprehensive Review
Quarter 4, 2018Free Cash Margin Index:Recession Lows Current Recent High
June 2019Median free cash margin increased to 4.39% for the twelve months ending December 2018, compared to 4.01% for the twelve months ending September 2018 and 4.59% in December 2017. Median free cash margin has increased for the first time compared to a previous quarter since March 2017. Median revenues have also seen a turnaround and have increased to $1,248.26 million in December 2018 compared to $1,238.43 million in September 2018, marking the end of four consecutives periods of falling revenues since the record high posted in December 2017. Driving the rise in free cash margin was an increase in median operating cushion, which rose to 15% in the December 2018 reporting period, compared to 14.29% in September 2018 and 14.45% in December 2017. This increase in median operating cushion was driven by a rather sharp decrease in SG&A spending as a percentage of revenue, which fell to 16.29% in December 2018, down from 17.63% in September 2018 and 17.26% in December 2017. A slight reduction in the cash cycle favored this period’s rise in free cash margin. The cash cycle fell to 47.77 revenue days in the December 2018 reporting period, down from 48.81 days reported in September 2018 and 52.16 days in December 2017. This decline in the cash cycle was driven primarily by a reduction in inventory days, which fell from 22.15 in September 2018 and 24.61 in December 2017 to a record low of 20.60 days in this most recent reporting period. Receivables days and payables days also declined from the previous quarter. Capital expenditures also increased to 3.79% in the current quarter compared to 3.58% in September 2018. This was a record high since the 3.89% in December 2016. Tax payments significantly increased from 0.55% in September 2018 and 0.80% in December 2017 to 0.96% in December 2018. Dividends and stock buybacks as a percent of revenue continue to climb, as they rose to 2.15% in December 2018, up from 1.92% in September 2018 and 1.59% in December 2017. The recent tax reform bill was signed into law in December 2017 with the hope that lower corporate taxes would increase capital spending and spur general economic growth. We are finally seeing an increase in capital spending as capital expenditures as a percent of revenue have increased for the first time since the tax law change took effect. We also see evidence of economic growth in the form of increasing median revenues. Finally, defying expectations for declining margins that typically occur late in an economic expansion, we saw an improvement in operating cushion.
Quarter 3, 2018Free Cash Margin Index:Recession Lows Current Recent High
January 2019Median free cash margin declined slightly to 4.01% for the twelve months ending September 2018, compared to 4.04% for the twelve months ending June 2018 and 4.67% in September 2017. Median free cash margin has continued its downward trend, as the metric has declined every quarter since March 2017, and is now in-line with pre-and-post-recession norms. Consistent with an economic slow-down, median revenues have fallen slightly to $1,238.43 million in the September 2018 reporting period, marking four consecutives periods of falling revenues since the record high posted in December 2017. While these trends are disconcerting, revenues and free cash flow remain relatively high compared with historical levels. Driving the decline in free cash margin was a reduction in median operating cushion, which fell to 14.29% in the September 2018 reporting period, compared to 14.35% in June 2018 and 14.37% in September 2017. This decline in median operating cushion was driven by a rather sharp increase in SG&A spending as a percentage of revenue, which climbed to 17.63% in September 2018, up from 16.99% in June 2018 and 17.59% in September 2017. A reduction in the cash cycle mitigated this period’s decline in free cash margin. The cash cycle fell to 48.81 revenue days in the September 2018 reporting period, down from 52.78 days reported in June 2018 and 51.48 days in September 2017. This decline in the cash cycle was driven primarily by a significant reduction in inventory days, which fell from 24.81 in September 2017 and 25.62 in June 2018 to a record low of 22.15 days in this most recent reporting period. The continued stagnation of capital expenditures remains a concern. Median capital expenditures as a percentage of revenue fell to 3.58% in the September 2018 reporting period, down from 3.68% in June 2018 and 3.70% in September 2017. This metric has now either fallen or remained flat in every consecutive reporting period since September 2016. In fact, this 3.58% figure is the lowest in the dataset since the September 2011 reporting period. Tax payments continue to fall, as the percentage of income taxes to revenue declined to 0.55% in the September 2018 reporting period, compared to 0.68% in June 2018 and 1.33% in September 2017. Meanwhile, dividends and stock buybacks as a percent of revenue continue to climb, as they rose to 1.92% in September 2018, up from 1.90% in June 2018 and 1.41% in September 2017. The recent tax reform bill was signed into law in December 2017 with the hope that lower corporate taxes would increase investment spending. However, capital expenditures have declined since then while dividends and stock buybacks have increased. While capital spending may still increase, to-date, it does not appear that tax reform is increasing long-term capital spending as was intended.
Quarter 2, 2018Free Cash Margin Index:Recession Lows Current Recent High
November 2018Median free cash margin declined to 4.04% for the twelve months ending June 2018, compared with 4.17% for the twelve months ending March 2018 and 4.90% in June 2017. Median free cash margin has continued its downward trend, as the metric has declined in each of the last six reporting periods, but remains within pre-and-post-recession norms. Median revenues have fallen slightly to $1,268.80 million in the twelve months ending June 2018, and median cash and short-term investments have fallen to $145.83 million during this time as well. This marks the second consecutive period of falling revenues and cash balances. While these trends are disconcerting, revenues and free cash flow remain high relative to historical standards.
Quarter 1, 2018Free Cash Margin Index:Recession Lows Current Recent High
August 2018Median free cash margin decreased to 4.17% for the twelve months ended March 2018, compared with 4.59% for the twelve months ended December 2017 and 5.28% in March 2017. This metric has declined in each of the last five reporting periods, but is still aligned with pre- and post-recession norms. While median revenues declined slightly to $1,284.30 million in the March 2018 reporting period from the $1,320.15 million in the December 2017 reporting period, revenue growth is still intact as median revenues are up 13.46% year-over-year. In the twelve months ended March 2018, gross margin before depreciation increased slightly to 37.65%, up from 37.61% from the December 2017 reporting period and up from 37.38% from the March 2017 reporting period. Selling, general, and administration spending before depreciation fell for the fourth consecutive quarter. Median SG&A as a percent of revenue was 17.17% in the March 2018 reporting period, compared to 17.26% in December 2017 and 18.38% in March 2017. The cash cycle fell from 52.16 days in the twelve months ended December 2017 to 50.01 days in the twelve months ended March 2018. This was driven by a decline in inventory days from 24.61days December 2017 to 23.06 days in March 2018 and an increase in payables days from 25.50 days to 26.37 days during this time. Receivables days increased slightly to 53.32 days in the March 2018 reporting period, up from 53.05 days in the December 2017 period. Due to tax reform, income taxes as a percentage of revenue continued to fall, reaching an all-time low of 0.72% for the March 2018 reporting period, following a previous all-time low of 0.80% for the December 2017 reporting period. All else being equal, with lower corporate tax rates, one would generally higher levels of capital expenditures. That said, capital expenditures as a percentage of revenue was 3.71% for the twelve month period ended March 2018, which lags behind pre- and post-recession norms. Rather than using their tax cut windfall to invest in capital projects, firms are largely spending their money dividends and stock repurchases, which, as a percentage of revenue continued to climb, reaching 1.65% in the March 2018 reporting period, compared to 1.59% in the twelve months ended December 2017 and 1.55% in the twelve months ended March 2017.
THE FREE CASH PROFILE: INSIGHT INTO THE CASH FLOW IMPLICATIONS OF GROWTH AN ANALYSIS USING 2017 DATAJune, 2018As the U.S. economy continued its recovery in 2017 amidst the passage of the recent tax reform bill, companies enjoyed the benefits of 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 20 non-financial industries, looking at all firms within those industries that have assets 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 5.98%, a notable increase from 2016’s median at 4.97%. There are 12 industries with a positive free cash profile, and 8 industries with a negative free cash profile. 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. It is important to note that although industries have median positive (negative) free cash profiles, a number of companies within those industries may have negative (positive) free cash profiles. Data for this research were provided by Compustat’s Capital IQ database.
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| 2017 |
AN EXAMINATION OF THE FREE CASH FLOW COVERAGE OF DIVIDENDS AND STOCK BUYBACKSDecember 2017Firms are only capable of sustainably maintaining their dividend payouts provided they are generating sufficient free cash flow. Our objective is to examine the capacity of firms in the S&P 500 to generate sufficient free cash flow to cover dividends and stock buybacks. Our sample consists of the non-financial and non-real estate firms in the S&P 500 for the period 2012 through 2016, excluding those firms that do not pay a dividend. We find that firms in the telecommunications services, information technology, and health care sectors have produced sufficient cumulative free cash flow to cover their dividend payouts and stock buybacks over the 2012 through 2016 timeframe. While firms in the consumer staples, materials, industrials and consumer discretionary sectors did not cover their dividends and buybacks with free cash flow, they were able to cover their dividends. Companies in the energy and utilities sectors generated the least free cash flow relative to their dividend payouts and stock repurchases and were unable to cover their dividends over the study period. The results include free cash flow, dividends and buybacks for the nine sectors studied for each year, 2012 through 2016, as well as the top three and bottom three performers in each sector across the five-year study period and individual results for each dividend paying firm in the S&P 500 for 2016.
Cash Flow Trends and Their Fundamental Drivers: Comprehensive ReviewQuarter 2, 2017Free Cash Margin Index:Recession Lows Current Recent High
October 2017Median free cash margin increased to 4.90% for the twelve months ended June 2017 compared with 5.28% for the twelve months ended March 2017 and 4.64% in June 2016. This metric is down slightly from the last reporting period, but is still running well above pre- and post-recessions norms. Similar fluctuations in free cash margin have been seen in other periods with healthy economic growth, and this would appear to be no different. This sentiment is supported by continued revenue growth during the June 2017 reporting period. Median revenues increased to another record level of $1,151.55 million in June 2017, up to 13.1% year-over-year from $1018.28 in June 2016. Cash flow data is also suggestive of positive economic conditions, as cash and short-term investments grew to a record $147.47 million. However, this revenue and cash flow growth is still not translating into a much-anticipated increase in capital expenditure investments, which would likely enhance economic growth. Capital expenditures declined from 3.93% of revenue in June 2016 to 3.74% in June 2017. Tax reform holds the potential to unlock cash and short-term investment balances and drive a renewal in capital expenditure spending. Factors impacting free cash margin were operating cushion, or operating profit before depreciation, which improved to 14.52% during the twelve months ended June 2017 from 3.74% in June 2016. This was driven by rising gross margins and a drop in SG&A expenses. The decline in free cash margin could be attributed to a rise in the cash cycle, which increased to 50.68 days in June 2017, up from 50.31 days in March 2017. The primary drivers of this change were increases in accounts recievable days and inventory days, offset by rising accounts payable days. The increase in inventory days may indicate an expecation of higher revenue growth. Looking at individual industries for the reporting period ending June 2017, free cash margin was stable in seven industry groups, higher in eight, and lower in five. Data for this research were provided by S&P Capital IQ’s Compustat database.
CORPORATE REPORTING OF OTHER COMPREHENSIVE INCOMESeptember 2017In this study we examine other comprehensive income (OCI) for the firms comprising the S&P 100 during the 2013 to 2015 timeframe. Our objectives are to determine what items of gain and loss are included in OCI and thus excluded from net income and to see if there is a systematic tendency for companies to keep more losses than gains in OCI. We seek to understand which OCI components show more unexpected losses and what impact each item of OCI will have on future earnings. We review all gains and losses listed as part of other comprehensive income, examine the average magnitude and distribution of these items, and analyze the effect of OCI reclassifications on net income. We seek to determine what OCI line items give most leeway to executives in managing earnings and hiding significant risk exposures. All S&P 100 companies in our sample reported items of other comprehensive income/(loss) in their 2013-2015 annual financial statements. Our findings show that losses are more likely to be reported on the statement of other comprehensive income than gains. Further, in two of the three years examined, the magnitude of losses included in OCI are greater than the magnitude of gains. Overall, these findings imply that companies are engaging in selective earnings management by reporting losses in OCI and excluding them from net income. The impact of different OCI components on earnings varies with unrealized investment losses and negative foreign currency translation adjustments being the primary drivers of total other comprehensive loss. Overall, our findings show that all OCI items should be treated as a precursor of future net income. In the sample, 43 companies reclassified gains and losses from AOCI to the income statement over the period of 2013-2015. Derivative and investment re-measurements were transferred to earnings most frequently. When OCI gains and losses were realized and recorded in net income, they often had a material impact on earnings. Our findings affirm a general tendency for companies to delay recognition of losses by keeping them in OCI. By leaving material losses “on paper” and out of earnings, companies can paint their performance in a more positive light. Therefore, reviewing OCI information should be part of the due diligence process of every analyst and investor. OCI information can enhance valuation and performance analysis by highlighting significant risk exposures and by helping readers to anticipate the impact of future reclassifications on earnings.
Quarter 1, 2017Free Cash Margin Index:Recession Lows Current Recent High
Median free cash margin increased to 5.28% for the twelve months ended March 2017 compared with 4.31% for the twelve months ended March 2016 and 3.53% in March 2015. This metric is up noticeably and is presently running well above pre- and post-recession norms. Free cash margin hasn't been at this level since the Great Recession when, in an effort to survive, companies cut inventories and capital spending significantly. Helping to drive free cash margin higher, operating cushion, or operating profit before depreciation, improved to 14.39% during the twelve months ended March 2017 from 13.53% in March 2016. An improvement in cash cycle is another driver of improved cash margin, as the cash cycle decreased to 50.31 days in March 2017, down from 53.23 days in December 2016. The primary drivers for this change were reduced receivable days and inventory days, as well as falling accounts payable days. Revenue growth continued and hit another all-time high during this reporting period. Median revenues increased to $1,131.96 million in March 2017, up to 14.8% year-over-year from $985.91 in March 2016. Also during this period, median free cash flow for our sample surpassed $50 million for the first time. However, this revenue and cash flow growth is still not translating into a much-anticipated increase in capital expenditure investments, which would likely enhance economic growth. Capital expenditures declined from 4.02% of revenue in March 2016 to 3.77% in March 2017. Cash flow data for the twelve months ending with the first quarter of 2017 suggest positive economic conditions, as companies are able to generate ample cash flow and improve free cash margin even as revenues are growing. Looking at individual industries for the reporting period ending March 2017, free cash margin was stable in six industry groups, higher in ten, and lower in four. Data for this research were provided by S&P Capital IQ’s Compustat database.
THE FREE CASH PROFILE: INSIGHT INTO THE CASH FLOW IMPLICATIONS OF GROWTH AN ANALYSIS USING 2016 DATAJune 2017The U.S. economy continued its recovery in 2016, and companies enjoyed the benefits of 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 20 non-financial industries, looking at all firms within those industries that have assets 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 4.97%, a notable increase from 2015’s median at 3.56%. There are 12 industries with a positive free cash profile, and 8 industries with a negative free cash profile. 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. It is important to note that although industries have median positive (negative) free cash profiles, a number of companies within those industries may have negative (positive) free cash profiles.
Quarter 4, 2016Free Cash Margin Index:Recession Lows Current Recent High
May 2017Median free cash margin increased to 5.21% for the twelve months ended December 2016, compared with 4.96% for the twelve months ended September 2016 and 4.35% in December 2015. This metric has now reached a post-recession high. Helping to drive free cash margin higher, operating cushion, or operating profit before depreciation, improved to 14.16% during the twelve months ended December 2016 from 13.72% in 2015. Stable gross margins, along with declining SG&A and capital expenditures contributed to the improvement in operating cushion. This improvement helped to offset an increase in the cash cycle, which rose to 52.23 days in December 2016, up from 50.37 days in 2015. The primary drivers for this change were increases in accounts receivable days and inventory days, as well as falling accounts payable days. Top line revenue reached an all-time high during this reporting period. Median revenues increased to $1,110.19 million in December 2016, up to 8.2% year-over-year from $1,025.88 in 2015. However, this revenue growth did not translate into increased capital expenditure investments, which declined from 4.01% of revenue in December 2015 to 3.89% in 2016. This softness in capital expenditures is not consistent with a robust economy, but it could possibly improve with tax reform. Overall, cash flow data for the twelve months ending with the fourth quarter of 2016 suggest an economy that continues to improve, but still lacks enough stability to attract long-term capital investments. Looking at individual industries for the reporting period ending December 2016, free cash margin was stable in five industry groups, higher in twelve, and lower in three. Data for this research were provided by S&P Capital IQ’s Compustat database.
AN EXAMINATION OF FACTORS AFFECTING FINANCIAL STATEMENT PLACEMENT ORDERMarch, 2017Anecdotal data suggest that firms are using the placement order of their financial statements to provide emphasis and affect perception about financial performance and position. Our objective is to see if we can identify systematic differences across firms that would help explain the financial statement placement order employed. We identify a sample of 400 public companies drawn from four different revenue quartiles. In addition to financial data for each firm, we identify the sector in which each firm operates and the firm’s auditor. We find that the balance sheet is much more likely to be the lead-in financial statement. Of the 400 companies in the sample, 272 (68.00%) present the balance sheet first while 127 (31.75%) present the statement of operations (income statement) first. In examining the factors that may drive the lead-in financial statement decision, we note that firms leading with the statement of operations are larger based on revenue and total assets. Further, they are more profitable, reporting a higher return on equity and higher net margin. Their asset turnover and operating cash margin are also higher. Finally, likely attesting to their larger size and debt service capacity, the firms leading with the statement of operations also report higher financial leverage. The results observed in this study, that is, the prevalence of the balance sheet as the lead-in financial statement, are also generally supported by the results observed for the ten industry sectors examined. Materials and Utilities are exceptions. Clients of Big 4 auditors also tend to report the balance sheet first. Here again, however, because their clients are likely larger in size than firms in the sample as a whole, the prevalence of the balance sheet as the lead-in financial statement is not as strong as observed in the sample as a whole. However, for non-Big 4 auditors, firms that likely audit smaller companies than the Big 4 auditors, the balance sheet is reported as the lead financial statement more frequently than in the sample as a whole. These results are relevant to CFOs, auditors, analysts and investors.
Quarter 3, 2016Free Cash Margin Index:Recession Lows Current Recent High
January 2017Median free cash margin increased to 4.96% for the twelve months ended September 2016, compared with 4.64% for the twelve months ended June 2016 and 3.74% in September 2015. The metric now sits above the upper end of its historical range of between 3.00% and 4.50%. Helping to drive free cash margin higher, operating cushion, or operating profit before depreciation, improved to 13.70% during the twelve months ended September 2016 from 13.64% in 2015. Declines in income taxes and capital expenditures also helped to improve free cash margin. A notable development during the most recent reporting period was the continued increase in median revenues. The metric increased to $1,052.29 million during the twelve months ended September 2016, up 5.2% from $1,000.30 in 2015, and is nearing its all-time high of $1,066.79 recorded in June 2014. The cash cycle increased to 50.26 days in the September 2016 reporting period, up from 48.88 days in 2015, driven higher by increases in accounts receivable days and inventory days, offset partially by an increase in accounts payable days. Capital expenditures as a percent of revenue declined slightly, to 3.96% in the period ended September 2016 from 3.97% in 2015. Overall, cash flow data for the twelve months ending with the third quarter of 2016 imply an economy that is improving, but in measured steps. Looking at individual industries for the reporting period ending September 2016, free cash margin was stable in five industry groups, higher in twelve, and lower in three. Data for this research were provided by S&P Capital IQ’s Compustat database.
Earnings Quality: Reports on Individual Companies and IndustriesIn 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. The Sustainable Earnings Indicator and Implications for Earnings Trends, 02.01.18 EQI, Earnings Quality Trends: Stabilization, 05.07.16 A Long Term Perspective on the Cash Generating Capacity of Corporate America: Dell, 05.11.17 EQI, Earnings Quality Trends: Growing Concern, 10.03.18
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Excel Spreadsheets of Cash Flow Data and Graphs by Industry
Quarter 3, 2019
0. All Industries (non-financials)
1. Energy
2. Materials
4. Commercial & Professional Services
7. Consumer Durables & Apparel
9. Media
10. Retailing