On the Analysis of Firms’ Cash Flows

Executive Summary

Analysts generally view the income statement as the centerpiece of financial reporting. It supplies the primary data in the forecasting of subsequent periods’ earnings. To appreciate the primary data, analysts must assess the impact of the underlying accounting principles on reported earnings: Not all components of earnings have the same predictive consequences. Of particular concern is the distinction between accruals and cash flows. Its mix influences the perceived “quality of earnings”. To sort out the effect of accruals versus cash flows and the quality of earnings, analysts naturally turn their attention to the statement of cash flows.

Any attempt to assess a firm’s quality of earnings through an analysis of GAAP’s statement of cash flows gives rise to new questions. First, it is unclear whether GAAP’s narrow concept of cash is relevant. Second, the dichotomy between operating and financial activities is arguably too arbitrary. (An increase in accounts payable could be viewed as a financing rather than as an operating activity.) More generally, GAAP’s way of assigning transactions to the three major categories (operating, investing, financing) can be challenged and second-guessed.

Setting aside these classification problems, equity analysts still face a more basic issue. Unlike the income statement, the GAAP statement of cash flows lacks a bottom line. Although there seems to be a general consensus that “cash from operations” should provide the starting point, it is far from clear what analysts are supposed to do next. Neither textbooks nor practice provide much of a guide. In other words, analysts lack access to a roadmap that takes them from the beginning of a cash flows analysis to the end. And the end ought to indeed correspond to a bottom line, in a spirit no different from the way earnings correspond to a bottom line for the income statement. With such a cash flow bottom line, one can proceed to assess the quality of earnings and estimate earnings on a recurring basis.

This paper proposes that the analysis and evaluation of cash flows is best done when based on what is referred to as modified cash accounting (MCA). MCA’s structural underpinnings rest on a “regular” financial reporting framework. The critical attribute of MCA concerns the assets/liabilities recognized. MCA includes only cash and other assets/liabilities judged to approximate cash (or the negative thereof). Hence the word “modified” is shorthand for the idea that there can be assets/liabilities other than cash because these are deemed sufficiently similar to cash. This balance sheet foundation serves as a means to an end: the preparation of an income statement without accruals.

The proposed MCA cash earnings statement goes beyond providing a bottom line. It also identifies various line items and subtotals. Consistent with financial statement analysis textbooks, the MCA cash earnings statement dichotomizes between operating and financial activities. A key subtotal identifies earnings due to operations on a cash (and approximate cash-equivalent) basis. To assess the quality of earnings, as a first step it makes sense to compare MCA’s and GAAP’s earnings. These quantities should be the same if one stipulates that the firm operates in a steady state; thus, under this presumed circumstance, MCA’s earnings provide the better measure of earnings. As a practical matter, one can think of a steady state as being valid when sales and capital expenditures have remained (approximately) the same; that is, they have neither grown nor contracted. The paper then considers what to do in the case of growth. It is shown how one can estimate an “appropriate” accrual conditioned on an estimate of the intrinsic business growth. With this procedure in place, one assesses the quality of earnings by comparing the two bottom lines after having added the estimated accrual to the MCA bottom line. Though the methodology raises a number of conceptual and practical issues, the paper offers solutions to these.