On the Analysis of Firms' Cash Flows
Posted: 15 Jul 2009
Date Written: July 14, 2009
This paper revisits the whys and hows of cash flows analysis. In a context of equity valuation, three aspects are considered. First, we consider why there is demand for an analysis of cash flows that complements GAAP’s income statement. The issues here pertain to the ambiguity inherent in accruals, primarily due to current and past non-recurring items, and how one assesses the quality of earnings. Second, we suggest how an analysis of cash flows should be done to assess the extent of biases in accruals. We propose a framework of Modified Cash Accounting (MCA) which satisfies a crucial property: It works just like a regular income statement except that it eschews all accruals. Because a MCA statement depends on consecutive balance sheets (like any standard accounting framework), the core of MCA hinges on what assets/liabilities have been qualified as cash, approximate cash, and the negative thereof. It differs from GAAP’s statement of cash flows because it relies on a broader concept of 'cash,' and MCA has a clear format like an income statement. The paper motivates and shows in some detail how one develops a MCA statement. A final issue deals with how one can assess the quality of (GAAP) earnings statement by comparing it to a MCA statement. We start from the observation that MCA earnings and GAAP earnings should be the same under the ideal condition when the firm is in a steady state. We then discuss how one can estimate a firm’s current-period growth and use this to estimate a normal accrual; this number can then be added to MCA’s earnings to obtain a bottom-line that compares to GAAP’s earnings.
Keywords: quality of earnings, modified cash accounting, cash earnings, normal accrual
JEL Classification: M41, G17, G30, M20
Suggested Citation: Suggested Citation