Considering that a significant portion of our methodology at Chain Bridge Investing is focused on fundamental analysis, it should be no surprise that part of our evaluation process depends on the use of various metrics to develop a more complete evaluation of a company’s financial statements. Such metrics usually quickly and efficiently reveal the current nature of the relationships amongst items on the balance sheet, income statement, and the statement of cash flows.
This piece briefly explains the excess cash margin (“ECM”), a metric that we use during the evaluation of the relationship between a company’s operating income (income statement) and its operating cash flow (statement of cash flows). The ECM can provide an early warning to the investor that a company may soon experience earnings troubles.
The ECM is based on the fact that while operating income and operating cash flow are not expected to mirror each other in regards to size and magnitude, their growth rates must be similar in order for the growth of either item to be sustainable over time. Both operating income and operating cash flow are ways to measure the company’s earnings through the use of a different methodology. Operating income is calculated using accrual basis, while operating cash flow is calculated using cash basis. Basically, cash basis recognizes revenues and expenses only when cash is received or used, while accrual basis recognizes revenues and expenses when a transaction is completed even if no cash is received or used. The idea behind the accrual basis is that eventually cash will be received or used and it recognizes the future and past receipts and uses of cash at the present moment. As a result, operating income and operating cash flows should grow at similar rates.
The ECM is calculated as follows:
ECM = [(operating cash flow – operating income) / revenue] x 100
If operating income and operating cash flow are not growing at similar rates during the course of a few reporting periods, the ECM will most likely notify the investor who should further investigate the discrepancy. In order to be utilized properly, the ECM must be used and analyzed in a time series – one calculation of ECM will not reveal anything of significance to the investor. There are three patterns one must watch for:
- An increasingly negative ECM. Such a result indicates that either (a) operating income is growing faster than operating cash flow or that (b) operating income is declining slower than operating cash flow. This trend warrants investigation as it implies unsustainable behavior that may surprise investors in the near future.
- An increasingly positive ECM. Such a result indicates that either (a) operating cash flow is growing faster than operating income or that (b) operating cash flow is declining slower than operating income. Again, this trend warrants investigation as it implies unsustainable behavior that may surprise investors in the near future.
- ECM remains relatively flat over time. Such a result is usually good and indicates that both operating income and operating cash flow are growing at similar rates.
Nevertheless, not all discrepancies seen in the ECM will be the result of aggressive earnings management or a very manipulative management team. Most discrepancies in the ECM will be due to seasonal factors, cyclical events, temporary shocks, or the current stage the company is at in its life cycle. All these factors can distort the relationship between operating income and operating cash flow, thus distorting the ECM. Yet, the investor has two motivations to investigate these discrepancies: (1) determining the factors leading to different rates of growth between operating income and operating cash flow can force the investor to gain a better understanding of the company’s operations; and (2) such investigation does help the investor understand the extent of the company’s use of earning management and avoid companies with potentially unsustainable operating results.
For more details on cash flow accounting, ECM, and various other metrics an investor can employ, we recommend that one read Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance.