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Compensation and Cash Flow

Why many companies are using metrics from the cash flow statement, and not just the income statement, to measure annual performance and award bonuses.

Jeffery Immelt doesn’t believe that General Electric Co. should offer stock options and similar incentives to retain its chief executive. That’s one reason the CEO worked with his company’s compensation committee to connect his paycheck more directly to cash-flow performance metrics.

Starting in January 2004, GE will use performance share units in calculating Immelt’s equity compensation. In addition to his $3 million annual salary and a bonus not connected to cash flow (in 2002, $3.9 million), Immelt will receive 250,000 PSUs with a potential value of $7.5 million. The PSUs will vest in five years if — and only if — cash flow from operating actitivities rises an average of 10 percent annually during that time.

Although most companies haven’t gone so far as General Electric, many are headed in the same direction. There seems to be a groundswell of support for using metrics from the cash flow statement, and not just the income statement, to measure annual performance and to award bonuses.

Last fall, during an industry meeting produced by CFO Enterprises (the conferences division of CFO Publishing Corp.), IBM Corp. treasurer Jesse Greene told attendees that when managers at Big Blue miss working capital targets, their business units are charged the cost of capital — deflating their units’ cash flow numbers and ultimately lowering bonuses. (IBM will also reverse commissions in certain cases when sales managers fail to reach working capital goals.)

Other large companies, such as auto industry supplier Lear Corp. and food products maker Corn Products International, also tie part of their bonus compensation to cash flow. And relatively small private enterprises like Jamba Juice, a San Francisco-based maker of smoothies and healthy snacks, use the cash-flow connection to attract and retain employees.

In all, 20 percent of the largest U.S.-based, publicly held companies use a cash-flow metric to calculate short-term compensation, says Russell Miller, a principal at Mercer Human Resources Consulting. Although historical data is unavailable to measure the exact increase, Miller is confident that the number of companies linking bonus compensation to cash flow is rising.

Why Now?

Miller says that tethering bonuses to cash flow is not a new idea. Executives at private companies, who generally manage for cash flow and not earnings per share, usually make the connection. Adds Miller, “more-mature companies, like manufacturers (as opposed to dot-commers), have always considered the metric important.”

In general, companies are spending more time scrutinizing cash-flow metrics because there’s pressure on executives and compensation committees to ferret out more-accurate performance indicators, adds Miller. As a result, executives at public companies are being asked to report on cash flow, working capital, and return on invested capital as much as on earnings and revenues. “Behind the move to link compensation to cash flow is a governance mandate to ensure that bonuses are paid out for the right reason,” maintains Miller.

Post-Enron governance concerns have also inspired companies to cozy up to cash flow. Earnings per share, revenues, and net income are more easily manipulated than cash metrics, says Espen Eckbo, a finance professor at the Tuck School of Management at Dartmouth University. The professor reckons that the backlash from corporate malfeasance — as well as a rule expected this year from the Financial Accounting Standards Board, which would require companies to expense stock options — is likely driving the change in attitude regarding incentive compensation.

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