Net Income Versus Cash Flows

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Net Income Versus Cash Flows
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Statement of Cash Flows

• Net Income
• (Revenues Expenses)
• DOES NOT EQUAL
• Cash Flows
• (Cash Receipts - Cash Disbursements)

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Statement of Cash Flows Shows Cash Flows From

• Operations
• Investing
• Financing

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Cash Flows From Operations

• inflows from customer sales, interest
• outflows for supplies, salaries, interest, taxes

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Cash Flows From Investing

• inflows from selling securities, collection of
  loans, selling plant assets
• outflows for buying securities, making loans,
  buying plant assets

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Cash Flows From Financing

• inflows from selling stock, acquiring loans and
  bonds
• outflows for paying dividends, repaying loans and
  bonds

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Indirect Method for Cash Flows from Operations

• Start with Net Income
• Adjust for
• depreciation and non-cash items in income
• change in current assets
• change in current liabilities

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Net Income vs Cash Flows

• Net income includes accruals. Accruals reflect
  revenue when it is earned rather than when the
  cash is received.
• Accruals also reflect costs when they contribute
  to producing revenues rather than when they are
  paid.

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Accruals versus Cash Flows

• Net income can be disaggregated into cash flows
  and accruals
• Net Income
• depreciation
• -growth in non-cash working capital
• Cash Flows from Operations
• Net Income CFO Accruals
• where accruals growth in non-cash working
  capital depreciation

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What is the purpose of accruals?

• Over the life of the company, cash flows and
  earnings will equal because all accruals will
  ultimately be realized in cash.
• However, investors are not willing to wait for
  the company to go through liquidation to get a
  performance measure.
• The purpose of accruals is to fix the timing
  problems with cash flows. Work performed this
  period is reported as revenue even though the
  cash could be collected the year prior to the
  sale, the year of the sale, or the year after the
  sale.
• Accrued earnings are expected to better reflect
  firm performance than cash flows.

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Dechow (1994)

• Dechow (1994, JAE) examines the relation between
  stock returns and earnings and cash flows. She
  observes the R-square from the regressions to
  determine whether earnings or cash flows better
  explain stock market returns.
• A higher R-square between the performance measure
  and stock returns suggests that the information
  in the performance measure is consistent with the
  information that investors use to value the firm.
  

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Dechow (1994)

• For all three periods, earnings is more strongly
  related to returns than cash flows.

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Dechow (1994)

• Dechow finds that accruals has a greater
  advantage over cash flows for companies with long
  operating cycles.
• Dechow finds that special items diminish the
  ability of earnings to explain returns for
  quarterly and annual periods.

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Earnings versus Cash Flows

• These results suggest that earnings provide
  better information for explaining stock returns
  than cash flows.
• However, one should not focus on only one
  measurement. Both earnings and cash flows
  provide information.
• Other research has shown that cash flows provides
  incremental information over earnings.
• This suggests that while cash flows is a poor
  SUBSTITUTE for earnings, it is a good COMPLEMENT
  to earnings.

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Accruals Versus Cash Flows

• Other research suggests that cash flows and
  accruals have differential implications for
  future profitability.
• Sloan (1996) finds that accrued earnings are less
  persistent than cash earnings.

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Accruals Versus Cash Flows
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Accruals and Earnings Management
Source Dechow, Sloan and Sweeney (1996)
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Accruals versus Cash Flows

• Accruals are less persistent than cash flows.
• Sloan (1996) shows that the market does not
  appear to take the lower persistence of accruals
  into account in valuation.

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Accruals versus Cash Flows
Source Sloan (1996)

• Stocks in the lowest decile of accruals
  outperform stocks in the highest decile of
  accruals.

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Growth in Net Operating Assets

• Just as profitability can be disaggregated into
  accruals and cash flows, growth in net operating
  assets can be disaggregated into accruals and
  growth in long-term net operating assets.
• NI CFO ACC
• GrNOA GrLTNOA ACC
• Fairfield, Whisenant and Yohn (2003) show that
  ACC and GrLTNOA have similar implications for
  future profitability (lower persistence).

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Growth in Net Operating Assets

• Fairfield, Whisenant and Yohn (2003) find
  equivalent abnormal returns from hedge portfolios
  based on GrLTNOA as from hedge portfolios based
  on ACC.
• The market appears to overvalue both accruals and
  growth in long-term net operating assets.

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Steps to Prepare Statement of Cash Flows

• Obtain beginning and ending balances for the
  balance sheet items
• Prepare a T-account worksheet
• Explain the change in each non-cash account for
  the period
• Sum of Operating Activities, Investing Activities
  and Financing Activities should equal the change
  in cash

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Preparing the Statement of Cash Flows

• Patton Corporation