On the heels of last year’s economic recovery, US companies have improved brilliantly this year as generators of free cash flow, mostly by tying up less cash in working capital, a new study finds.
'CFOs as a group have once again demonstrated their ability to improve on the generation of cash,' says Charles Mulford, an accounting professor at Georgia Tech and co-author of the study. 'And they’ve done it across the board, in terms of the levers they have to pull and the metrics that we have to measure their performance.'
In what they call 'a notable increase' from the 2015 median of 3.56%, the authors report that the median 'free cash profile' for 20 non-financial industries rose to 4.97% in 2017. Reported as a percentage of annual revenue, the profile 'measures the capacity of a firm to generate free cash flow as it grows revenue,' according to the study, which is based on the financial statements of 2,595 companies with assets greater than $100 million.
(In simplest terms, for every dollar of sales growth, the median company can now be expected to throw off about 5 cents of free cash flow,' says Charles Mulford, an accounting professor at Georgia Tech and co-author of the study,' says Charles Mulford, an accounting professor at Georgia Tech and co-author of the study - a rise of a penny over last year’s expectations for this year.)
The 141-basis-point rise in the forward-looking metric stems from the companies’ 2016 performance in four areas: operating cushion, operating working capital, capex, and taxes paid. (To learn how the free cash profile is calculated, see 'How the Free Cash Profile Works,' below.)
Defined as operating profit before non-cash depreciation and amortization, the median operating cushion grew by a whopping 89 basis points. (See the tables below.) In addition to last year’s economic recovery, Mulford attributes companies’ surging profits to improvements in their ability to spawn higher gross margins and slash their selling, general, and administrative expenses.
To get the biggest cash flow bang out of their surging earnings, companies focused on their ability to remove as much working capital from their operations as possible, Mulford and co-author Mark Jacobson write. Last year, the median company cut its operating working capital by 69 basis points, according to the report.
Largely, company reductions in working capital stemmed from cutting their accounts receivable, carrying less inventory, taking more time to pay their bills, and getting more of their revenues upfront, according to Mulford.
'It’s a management objective to to minimize the amount of money that is tied up in non-return-generating assets,' he adds. 'From that point of view, you want to minimize investment in receivables and inventory and maximize cash provided by payables and deferred revenue - and that’s what [senior executives are] doing.'
Besides the big boosts in operating cushion and working-capital performance, companies got a 17-basis-point bump in 2016 free cash flow by paying less taxes, according to the study.
Mulford is eager, however, to express concern that the rise in cash came partly through cutting capex by 12 basis points. Diminished investment in capital spending 'is not what the U.S. economy needs,' he says. 'The capex that we lost during the Great Recession has not been replaced yet.'
The lack of corporate investment in buying land and building and maintaining plants and equipment represents a short-term outlook, according to the professor. However, the study is based on last year’s data, notes Mulford, and the years-long trend away from capex could abate this year. 'I’m hopeful,' he says.
The professor acknowledges that there’s no standard definition of the free-cash-flow metric that forms the basis for his six-year-old study. Indeed, the Securities and Exchange Commission has warned 20 companies over the last six months about playing fast and loose with the metric.
'Every company can define it how it sees fit,' he says, noting that for some companies, it’s simply synonymous with earnings before EBITDA. It’s very easy to manipulate the number and make it look much better than it is.'
Standing by his own definition - operating cash flow less preferred dividends and net capex - Mulford understands why the SEC is currently cracking down on misuse of the definition. 'The SEC has observed that companies have gotten fairly loose,' he says. 'And they decided, enough is enough.'
This article was originally published on our sister site CFO.com