Mind the Gap: The 2003 Cash-Flow Scorecard

A new study of operating cash flow and earnings for the 87 nonfinancial companies in the Standard and Poor's 100 suggests that the recent upturn in corporate profits may not be sustainable.

Is the recent upturn in U.S. corporate profits likely to last? Unfortunately, a new study comparing trends in cash flow with those in earnings for the largest blue-chip companies provides ample reason for doubt.

The study, by the Financial Analysis Lab at the Georgia Institute of Technology’s DuPree College of Management, found a troubling gap between cash flow from operations and operating income last year for the 87 nonfinancial members of the S&P 100. DuPree found that the difference between operating cash flow and income last year for the median company in the group was almost 12 percent greater than average for the three years that ended in 2002.

While a small gap of this sort (which DuPree terms a company’s excess cash margin, or ECM) is not necessarily a troubling sign (whether positive or negative), a positive ECM in double digits reflects a heavy dependence on improvements in working capital and other boosts to cash flow that aren’t sustainable, simply because such gains aren’t generated by the growth of a company’s underlying business operations.

Unless more sustainable growth has materialized in 2003, which at this point is impossible to determine, the study suggests that operating cash flow will soon decline. So, ultimately, will earnings, observes Charles Mulford, an accounting professor who oversees the Georgia Tech lab. (Mulford is aided by analyst Michael Ely.) “At least some of the recent improvement in cash flow is from liquidating the balance sheet; it is not earnings-produced,” says Mulford. And, he asserts, “that kind of growth is not as sustainable.”

Ideally, in Mulford’s view, operating cash flow and earnings should grow more or less evenly over time. When they don’t, and one measure exceeds the other by a large margin, there’s reason to doubt that a company’s performance is as strong as either measure alone may suggest.

Mulford’s conclusions reflect the lab’s efforts to adjust the S&P 100′s figures for cash flow from operations and for net income for what the researchers consider nonrecurring and nonoperating items (see “Studying the Flow”, at the end of this article). Last year, a study by DuPree did the same with cash flow from operations alone (see “Tuning In to Cash Flow,” CFO, December 2002).

Off the Median

Of course, median figures paint the index’s performance picture with a particularly broad brush, and individual company performances vary widely. More than a few companies, in fact, have been doing much better than average. Among the standouts: Anheuser-Busch, Coca-Cola, and Wal-Mart Stores, each of which showed gaps between operating cash flow and income in 2002 that were less than 10 percent greater than the mean for the three-year period.

To be sure, 19 other companies exhibited ECM differentials of less than 10 percent for the period (see, “The ECM Scale” at the end of this article). But in many of those cases, including Oracle, Entergy, and Home Depot, a relatively low average ECM for the three years obscured wider year-to-year swings, which Mulford says may themselves be reasons for concern. “My hunch is that volatility in ECM reflects greater risk,” he says. And he contends that in some of these cases, such volatility may also reflect questionable accounting practices, though he’s quick to say, “I don’t want to point any fingers.”

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