Study: Cash-Flow Margins Declining

Now at 4.12%, Corporate America's free cash flow measured as a percentage of revenue will likely decline to its 2001 recession level of 2.43% or lower, research predicts.

Facing the risk of seeing their cash flows erode to a level not seen since the 2001 recession, companies can avoid the worst by staying focused on keeping their working capital requirements and capital expenditures down, a new study suggests.

To be sure, the current downturn has been chipping away at companies’ cash-flow margins — free cash flow measured as a percentage of revenue — for the past several quarters and will likely continue to do so, predicts Charles Mulford, director of the Georgia Tech Financial Analysis Lab and co-author of the study. But at 4.12%, the aggregate free-cash margin for Corporate America ”held up reasonably well” last year, the researchers conclude.

“Companies are holding up free cash flow even as profitability suffers by reducing working capital requirements and capital expenditures,” Mulford says.

Mulford and graduate research assistants Sohel Surani and Jason Blake have been conducting quarterly analysis of cash-flow trends for 20 nonfinancial industries for a series of rolling 12-month periods from the first quarter of 2000 through the fourth quarter of 2008. Mulford believes the free-cash margin reflects a company’s long-term financial health and “is particularly relevant during a recession.”

After all, he explains, free cash flow is the discretionary cash that companies can use, without disrupting operations, to make acquisitions, retire debt, pay dividends, and buy back stock. The free-cash margin is essentially a cash-flow profit margin that indicates what percent of revenue is left for shareholders in the form of discretionary cash flow, the authors say.

The metric had been hovering above 4.5% since 2002 before falling for the 12 months ended September 2008. Now at 4.12% as of December 31, 2008, the measure will likely decline to its 2001 recession level of 2.43% or even lower. Its last high was in June 2004, at 5.14%.

Indeed, the researchers are predicting “a continuing contraction of free cash flow of 50% or more from current levels.” For now, however, Mulford tells CFO.com, “corporate cash flow performance is still holding up.” However, he cautions, his latest study does not yet take into account the “worst of the recession effects,” which will show up in later studies.

For their reports, Mulford and his researchers look at 3,400 companies with market capitalization of at least $50 million. They found declining free-cash margin in 12 industries, four more than the previous quarter’s study. Industries that have seen decline in their free-cash-flow margin include the food and beverage (8.55%), technology hardware and equipment (4.41%), and auto (1.33%) sectors.

On the other side of the cash-flow spectrum, utilities and such food and staples retailers as Sysco Corp. and Wal-Mart Stores, improved their free cash margin last year, Mulford notes. Indeed, Wal-Mart ended its fiscal year 2008 with free cash flow of about $11.6 billion, compared to $5.7 billion during the same time period the previous year. CFO Thomas Schoewe has attributed that improvement to the company’s improved operating results, reduced capital spending, and better management of working capital, particularly with keeping inventory down. Under Georgia Tech’s calculations, Wal-Mart’s free-cash margin is 3.07%, up from 1.7% for the 12 months ended January 2008.

As for Sysco, its free cash margin of 2.91% stemmed from a reduction to capital expenditure from 1.61% of revenue in 2007 to 1.34% of revenue last year, the researchers note. They also attribute Sysco’s higher free-cash margin to a reduction in income taxes.

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