I love this time of year. Here in Washington, D.C., everything starts to look a little greener; we get to experience the blooming of the cherry blossoms and tulips. But for stock pickers (and workers expecting pensions down the road), new government rules for retirement contributions this year could signal another bloom worth watching this spring: Higher corporate cash flows.
New rules for pension contributions let companies put less money into their workers' pension funds starting in 2013. The hope is that more money will flow instead to growing businesses and creating jobs. While such changes could impact retirees later on, the rules also mean that one favorite metric for investors -- free cash flow -- could look much better on some corporate balance sheets for the next few years.
First, some basics: Free cash flows can be derived any number of ways, but in essence, they're the cash flows from operations (what the firm makes and spends in cash from its day-to-day business operations) adjusted for non-cash items like depreciation or deferred taxes and any change in the working capital of the firm (a change in the ratio of current assets to current liabilities).
The most recent iteration of the Pension Protection Act of 2006, signed in July of 2012, lets companies to institute a stable interest rate policy on their retirement obligations. In effect, the new rules will reduce the minimum required employer contributions to pensions by an estimated 15-20 percent, according to Buck Consultants. Without getting too far into the weeds, the idea is to reduce the minimum amount of money companies have to pay into defined-benefit plans with the expectation that those funds will instead be used to foster near-term growth. While that could mean the future obligation to retirees will increase at the expense of current dollars being used to further the company's business operations, investors analyzing earnings announcements should expect that money to flow to a different line on the balance sheet, potentially inflating free cash flow on the balance sheet.
These changes are expected to impact financial statements for up to the next three years. This means that the changes to cash flow are temporary, with implications that can last decades into the future as pension obligations continue to accumulate. It also suggests that in the short-term, companies that miss earnings and revenue but tout high free cash flow or high operating cash flow require some further evaluation before investing. An easy tip for estimating the effect that pension contributions have on cash flows is to reduce the cash flows from operations (from the statement of cash flows) by the net tax amount of change in contributions to pensions from the previous quarter.
This quick adjustment should give you a better picture of what activities are actually driving the spike in cash flow.
Kristen E. Owen is a Wealth Management Associate at Monument Wealth Management , a full service wealth management firm located just outside Washington, D.C., in Alexandria, VA. Kristen is not a registered investment advisor representative. Follow Kristen and the rest of Monument Wealth Management on their blog which can be found on their website, on Twitter @MonumentWealth, and on the Monument Wealth Management Facebook and LinkedIn pages.
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