Earnings or Cash Flows: Which is a Better Predictor of Future Cash Flows?
60 Pages Posted: 18 Oct 2017 Last revised: 14 Aug 2018
Date Written: August 10, 2018
We reexamine the relative ability of earnings and cash flows in predicting future cash flows to achieve two objectives: (i) reconcile the mixed evidence in the prior literature, and (ii) investigate the implications of temporal shifts in accrual accounting for trends in cash flow predictability. Three key insights emerge from our analyses. First, contrary to conventional wisdom, we find that cash flows are superior to earnings in predicting future cash flows. After evaluating several alternative explanations, we attribute the mixed evidence in prior research mainly to measurement errors induced by the balance sheet method of estimating cash flows. Second, we find that earnings’ ability to predict future cash flows is increasing over the period 1989-2015. However, this trend is attributable to the increasing predictive ability of cash flows rather than accruals. That is, while cash flows show an increasing ability to predict future cash flows over time, accruals display no such trend. Our findings are robust to US and international settings. Finally, we document that the increasing predictive ability of cash flows is associated with shortening operating cycles, decreasing working capital accruals, and increasing intensity of intangibles over time.
Keywords: Accrual accounting; Cash Flow Predictability; Valuation
Suggested Citation: Suggested Citation