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Centers & Initiatives

Financial Analysis Lab

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, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that 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 on 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.

 


September 2017

In 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.

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Quarter 1, 2017
Free Cash Margin Index:
Recession Lows

0.99%, 3.45% (Dec. 2000, Dec. 2008)

Current

5.28% (Mar. 2017)

Recent High

6.88% (Dec. 2009)

August 2017

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.


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June 2017

The 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.

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Quarter 4, 2016
Free Cash Margin Index:
Recession Lows

0.99%, 3.45% (Dec. 2000, Dec. 2008)

Current

5.12% (Dec. 2016)

Recent High

6.88% (Dec. 2009)

May 2017

Median 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.


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March, 2017

Anecdotal 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.

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Quarter 3, 2016
Free Cash Margin Index:
Recession Lows

0.99%, 3.45% (Dec. 2000, Dec. 2008)

Current

4.96% (Sep. 2016)

Recent High

6.88% (Dec. 2009)

January 2017

Median 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.


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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.

 

Excel Spreadsheets of Cash Flow Data and Graphs by Industry


Quarter 1, 2017