What’s Your Free Cash Flow Margin?

A new study tracks free cash flow as a percentage of revenue. Could this metric turn out to be the single most important measure of financial health during a recession?

Intuitively, financial executives know that a recession puts the brakes on discretionary spending. Free cash flow dwindles, so that little is available for funding dividends, stock-buybacks, debt repayments, and acquisitions. And companies move into survival mode.

A new study, being released today, examines several factors driving cash flow trends, including a metric called free cash margin, which measures free cash flow as a percentage of revenue. Because free cash flow comes with no strings attached — meaning it is truly discretionary — spending from it does not affect the company’s ability to generate more. The metric “indicates what percent of revenue is left for shareholders in the form of free and discretionary cash flow,” writes study coauthor Charles Mulford, director of Georgia Tech’s Financial Analysis Lab, who penned the report with research assistant Sohel Surani.

In practical terms, if a company sells a product for one dollar, the free cash margin identifies how many cents the shareholder can take home without stifling the company’s positive cash flow. In that respect, the metric provides companies with a cash flow profit margin, something many CFOs would have a keen interest in tracking, especially during a recession, posit the authors.

They contend that keeping a company’s free cash flow margin healthy is important for a very basic reason: Companies that consume cash must continually seek new sources of capital — and those sources will either dry up or become prohibitively expensive if a company does not show it is capable of generating positive cash flow. Indeed, “a company with profits that is unable to generate cash … will experience waning investor enthusiasm. It may take a while … however, [ultimately] a company must show an ability to generate free cash flow,” contend Mulford and Surani.

During the 12 months ending September 2008, free cash margin for non-financial companies in the S&P 500 — the study sample — declined to 6.70 percent from 7.31 percent for the prior 12 months. Nevertheless, those companies currently report a median $667 million of cash on hand, suggesting that the sample group has “ample” cash and short-term investments to weather the immediate financial crisis, opine the authors.

But there is no telling how far free cash margin might sink if the recession deepens or becomes more widespread, notes Mulford. The study says that median free cash margin bottomed out at 4.36 percent during the 2001 recession for the 12 months ending in March of that year. After that, the metric made a steady climb upward as the country entered a period of economic recovery. In fact, companies’ ability to generate cash, as measured by free cash margin, was “remarkably high” in recent years, notes the study.

Mulford, however, expects “a significant decline in the metric” if the recession deepens, because the affects of the last, and hardest-hit quarter to date, won’t be fully factored into financial results until later this year.

The study considers the potential effects of a drastic free cash margin drop of 300 basis points, which would bring the ratio from its recent peak of 7.80 percent to down near its historic low at 4.80 percent. Such a dip would translate into a median free cash flow decline for the S&P companies by about $250 million — a 40 percent cut in median free cash flow. A decline of 600 basis points, which would push the ratio to 1.8 percent —  significantly below its historical low — would decimate median free cash flow for the study companies, reducing it by nearly 90 percent, and leaving it barely above the break even point.

Interestingly, companies reported that operating cash margin improved slightly during the 12 months ending September 2008. That metric measures cash flow from operations — after interest charges and income taxes — divided by revenue. Mulford contends that the operating cash flow margin was bolstered by improvements in the operating cushion or profit companies reported.

For the 12 months ending September 2008, operating cash margin remained relatively flat at 13.75 percent compared to 13.70 for the previous 12-month period. As expected, operating cash margin also hit its low (11.13 percent) during the 2001 recession.

But despite the improvement in operating cash margin, increased capital spending pushed free cash margin lower. That’s because capital expenditures are the primary difference between the two cash margin measures, so broad changes in capital spending relative to revenue affects their relationship, explain the authors.

As a result, an increase in the free cash margin to operating cash margin ratio (see graph) indicates a decline in capital spending. Conversely, a drop in the ratio points to increases in capital spending. Again, the ratio hit bottom during the 2001 recession, coming in at 39.2 percent for the 12 months ending June 2001. Currently, the ratio is following a similar downward trend, dropping to 48.73 percent in the 12 months ending September 2008.

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