Twenty years ago, Charles Mulford was talking to the CEO of a high-tech start-up that had very ambitious growth plans. “I was very interested in the company,” he says, “but I questioned how they were going to finance their aggressive growth strategy. The CEO really surprised me when he said, ‘We’ll throw off cash as we grow.’”
That, Mulford says, “really made me rethink my attitudes toward cash flow and how it’s affected by growth.” Now, leading a team of researchers at Georgia Tech’s Financial Analysis Lab, Mulford has developed a new measure of free cash flow, one that ties it to anticipated revenue growth. Dubbed the Cash Flow Growth Profile, the measure seeks to predict the amount of incremental cash flow that will result from a given amount of growth in revenue.
“Growth is often considered to be a cash drain,” says Mulford, director of the lab and professor of accounting at Georgia Tech, but “it is not necessarily the case that growth must be financed.” Some companies, he says, actually generate more cash flow as growth accelerates. And whether a company does or does not, understanding the cash-flow implications of projected growth provides a useful window into what the next year will bring.
The Cash Flow Growth Profile is measured as a percentage—positive if the company can increase its cash flow as it grows, negative if its growth requires other sources of cash to support it. It consists of two parts: the Core Operating Growth Profile and the Free Cash Growth Profile. The former is expressed as the operating cushion percentage (operating cushion, which is defined as operating profit before non-cash depreciation and amortization, to revenue) less operating working capital percentage (operating working capital to revenue).
The Free Cash Growth Profile is similar except that it incorporates taxes and capital expenses into the calculations, since those two expenses tend to grow with revenue; thus it can be measured as the Core Operating Growth Profile minus income taxes paid to revenue minus capex to revenue.
Where to look for companies that display the usefulness of this metric? High-tech, of course, where high operating margins and typically low inventory needs spell cash generation par excellence.
The researchers looked at 11 companies in a range of information-technology sectors (hardware, software, telecom, services, and semiconductors) and used Microsoft as the Big Kahuna of the sector. The software giant didn’t disappoint: its core operating growth profile and free cash growth profile clocked in at 59.3 percent and 41.8 percent respectively. That is, for every added dollar in revenue growth the company can be expected to generate 59.3 cents in core operating cash flow and 41.8 cents in free cash flow. Mulford plans to extend the analysis to other industries.
The measures are useful to investors, the professor and his team argue, because they help an investor go beyond a focus on earnings and assess a company’s ability to translate growth into sustainable cash flow. Mulford acknowledges that what an investor may care most about is a record of profitable growth, regardless of what impact that has on cash flow. But eventually, he says, companies will have to show that they can generate free cash flow and thus not always be on the lookout for new sources of capital.