EBITDA VERSUS CASH FLOWIn assessing next year’s economic outlook, a key question is the behaviour of corporate investment. Given the traditionally rather steady pace of private consumption growth during a recovery, the dynamism, or lack thereof, of gross fixed capital formation by companies will make the difference between a subdued or robust recovery. Pending the introduction of a vaccine, uncertainty –both health-related and economic- should remain high and act as a headwind to corporate investment[1]. However, GDP is growing again and with that, company profits should increase. As shown in chart 1, in the US, reported EBITDA -a measure of company profitability- is still trending down though less than before and financial analysts are expecting a pick-up over the course of the next 12 months. EBITDA is quite correlated with cash flow[2], so one should expect an improvement of this metric as well as the recovery continues[3]. From a macroeconomic perspective, cash flow is important because it is one of the drivers of gross fixed capital formation by companies. One could argue that at the current juncture, an increasing number of companies are accumulating cash, whilst being reluctant to invest because of the uncertainty. When the latter drops because the health situation improves, this cash could be unleashed and cause an acceleration of economic growth. As shown in chart 2, in the US, in recent recessions, cash flows increased well before the pick-up of corporate investment. This shouldn’t come as a surprise. Companies may still feel uncertain in the early phase of a recovery. According to research of the European Investment Bank, in absolute value terms, a decline in uncertainty has a smaller impact on corporate investment than an increase. Weaker firms also react more strongly to an increase in uncertainty.[4] Unsurprisingly, the negative relationship between cash flow uncertainty on the one hand and corporate investment and corporate employment on the other hand is also stronger in recessions.[5] Companies may also prefer to pay back debt. Empirical research shows that, in the longer run, investments are sensitive to cash flow, but in the short run, financially constrained companies will use the improved cash flow to reduce leverage, rather than increase investment.[6]
What insights do these results provide for the current recovery? First, the good news is that higher corporate cash flow is eventually followed by increased investments. However, there is a delay. This means that in the near term, household spending and government expenditures will be key for the pace of GDP growth. Second, financially weaker companies invest relatively speaking less. This is an issue considering the increase in corporate indebtedness following the collapse in activity earlier this year and calls for a policy aimed at strengthening the capital base of companies. Third, cash flow uncertainty matters. Here again economic policy has a role to play by supporting the recovery –monetary and fiscal policy- but also by providing a perspective on the policy stance for the next several years. Central banks do this by providing forward guidance. Governments could do the same and offer visibility in terms of taxes and expenditures.
CASH FLOW AND CORPORATE INVESTMENT
