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Positive Economic Commentary

Corporate Cash Flow — Thank Goodness For Depreciation
May 02, 2003

The Fed's flow of funds database is just packed with nuggets of information. Unfortunately, these days those nuggets are radioactive when it comes to the economy. For example, one of the nuggets I just discovered is that for the past three years running economic depreciation for nonfinancial corporations has accounted for over 90% of their domestic cash flow. (Cash flow is defined here as essentially book profits minus accrued tax liabilities, dividend payments, and depreciation.) As can be seen in Chart 1, this is the highest depreciation has been as a percent of cash flow in the post-WWII period. In 2001, depreciation accounted for slightly over 100% of cash flow!

Chart 1

This nugget or "factoid" has some disturbingly interesting implications for business capital spending and/or the stock market. If corporations use all of their cash flow to purchase plant and equipment when most of their cash flow is generated by economic depreciation, they will be essentially "running in place" with respect to increasing their capital stock. All that they will be doing is replacing worn out or obsolete equipment. This cannot be good for corporate profits or productivity going forward. A growing corporation usually is investing in net new plant and equipment, not just replacing the broken down stuff. And isn't capital deepening - increasing the ratio of capital to labor - one of the principal ways of increasing labor productivity? Again, if a company is just replacing the fully-depreciated equipment, the capital stock is not increasing. Rather, it is just staying the same. By the way, that productivity miracle that Fed Chairman Greenspan never misses an opportunity to tell us about is looking a bit less miraculous now. The first quarter 2003 data showed year-over-year nonfarm productivity growth slowing to 2.3% from 4.1% in the fourth quarter of 2002. So, it looks as though we are going to need increases in the capital stock if Greenspan is to be able to keep singing the glories of productivity growth with a straight face through June of 2006.

But using all of one's cash flow to invest in plant and equipment may be a "best case" outcome these days. There might be more immediate pressing needs for that cash flow than capital spending. One that comes to mind is debt repayment. Despite a dramatic slowdown in the growth of corporate borrowing last year, the debt-to-net worth ratio for nonfinancial corporations moved to a post-WWII high (see Chart 2). But even if corporations do not paydown debt, with their record high debt-to-net worth ratio, will they be able to borrow to invest above the depreciation rate without risking a credit-rating downgrade?

Chart 2

Another pressing need or "claim" on cash flow is pension fund contributions. We read almost daily how corporate defined benefit pension funds in the aggregate are underfunded because of the bear market in stocks. Chart 3 shows how pension fund contributions have tailed off in the past three years. All of that is changing now. Pension fund contributions will become in the years ahead rising claim on corporate cash flow, perhaps at the expense of capital spending.

Chart 3

Of course, corporations could cut their dividend payouts to free up some cash flow for capital spending. But that has some obvious negative implications for stock market values going forward. Or, corporations could raise funds for capital in a way in which they have not for a number of years now - float stock. But with the public's appetite for corporate equities seemingly sated now, additional supply would not be very bullish.

In sum, unless we see a sustained pick up in corporate cash flow from some source other than economic depreciation, net increases in the capital stock and increases in equity prices are likely to be disappointing.

Paul Kasriel
Director of Economic Research

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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