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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...