U.S. companies are increasing inventory faster than consumers are buying their goods, setting up businesses for a challenging close to 2016. In a June 2016 policy paper entitled "The Cash Flow Mirage," equity analysts from Goldman Sachs found that "inventory growth is outpacing sales growth in the majority of sectors we track." The problem was most pronounced in capital-intensive sectors — year-over-year inventory growth outpaced sales growth by an average of 9.4% for the automobile, defense, IT supply chain, semiconductor and agribusiness sectors.

This is a worrisome sign for the economy. These capital goods sectors built up their productive capacity during recent years and, in many cases, expanded through cheap debt financing. If consumer demand is not sufficient to absorb the extra inventory, companies might not generate enough earnings to pay off bondholders and please investors.

Goldman reports that many companies already began drawing down inventories, or selling existing product without replacing it with new manufactured product. This can artificially boost current cash flow and net income because money isn't leaving as quickly through the production process. If real demand remains lower than predicted, however, companies may need to be more creative in order to liquidate or write down inventory, and maybe even downsize. It is very difficult to maintain high equity valuations when forced to slow down present production.

Liquidating Inventory After Malinvestment

When companies make projections for future operations, they have to balance the present costs of their production process with the future value of their final goods and services. Longer production processes are riskier, as it is more difficult to project several years into the future. If companies get the wrong signal about either present costs or future demand, the entire economy can slump. The problem is not necessarily overproduction or overinvestment but rather the wrong level of production or investment in the wrong sectors (i.e. "malinvestment").

Capital goods industries tend to be the hardest hit in such cycles. This is because it takes more time to reveal malinvestments for companies with longer or more capital-intensive production processes. Thanks to super-low interest rates since 2009, the relative value of future cash flows became exaggerated, since near-term investment costs (i.e. cost of funds) were much lower than in a normal-rate environment. It is much easier to justify building another manufacturing plant for automobiles or semiconductors when borrowing costs are at historic lows.

Those calculations were made assuming that future inventory could move off the shelves and sell at a reasonable market price. Unfortunately, inventory was already stockpiling in 2015. In September 2015, the U.S. Department of Commerce reported that inventory-to-sales ratios were at their highest level since the last months of the Great Recession. If not for widespread inventory drawdowns, cash flow margins for the average American company might have been flat in 2015.

That is not a sustainable revenue stream, and it should make some bondholders and shareholders uncomfortable if sales figures do not pick up again. If the misalignment between producers and consumers is severe enough, expect a rise in corporate defaults and downward pressure on the U.S. economy.

Debt-Adjusted Cash Flow Analysis

Net income and free cash flow are very important to fundamental investors, but they often overreact or underreact to changes in a corporation's capital structure or taxes. When companies typically have very high debt ratios and/or high taxes, investors can use the debt-adjusted cash flow (DACF). The DACF looks at cash flow independent of financing considerations, which makes it easier to compare companies with very different working capital structures. Investors may want to incorporate the DACF method as a way to look past inventory drawdowns or temporary debt financing concerns.