Cash Flow Components Research Articles

Impending Bankruptcy: Examining Cash Flow Pattern of Distress and Healthy Firms

Abstract Studies have proven that information on earnings has become less relevant to measure company performance during distressed situation. A relatively simple and convenient way to analyze a company's financial status is by using cash flow information. The present study examines eight types of cash flow patterns used as an alternative tool to predict financial distress incidence. The cash flow patterns derived from positive and negative signs of cash flow components which consist of operating, investing and financing activities. The data collected consists of 124 Malaysian public listed companies covering the period of 2006 until 2013. The main objective of the study is to find out whether there is any significant relationship between cash flow patterns and financial distress incidence. The results found that companies are more likely to experience financial distress situation when the company generates positive cash inflow from daily operation activities and use the cash generated to finance future investment and long term debt. Besides, the companies are also more likely in distressed situation when they are unable to cover its short term obligation due to insufficient cash inflows generated from the main operating activities. Distressed companies are more likely to acquire external financing since the excess of cash generated from operating activities is insufficient. When the company experienced outflows in all operating, investing and financing activities, there is high tendency for the company to go bankrupt. The results also revealed that there is a significant difference between distressed and healthy companies in incidence of different patterns of cash flow.

The Profitability Premium: Macroeconomic Risks or Expectation Errors?

Macroeconomic risks only partially capture the profitability premium, while adding a misvaluation factor based on investor sentiment helps explain a substantial amount of it. The profitability premium mainly exists in firms whose market valuations are inconsistent with their profitability and therefore subject to ex-ante expectation errors during high sentiment periods. Direct evidence shows that firms with high profitability but low market valuation have significantly higher abnormal earnings announcement returns, analyst earnings forecast errors and forecast revisions than firms with low profitability but high market valuation. Return decomposition further confirms that the profitability premium is driven by the unexpected cash-flow component.

Is Earnings Information Superior to Net Income as a Measure of Future Earnings? A Study on Accruals and Real Earnings Management

This study examines the incremental information content of components of earnings by regressing future net income of earnings’ components in a series of multivariate models. We find that the components of operating cash flow and accruals provide more information to effectively predict future profitability, particularly when we dismantles financial measurements into various combinations of operating cash flow and accrual-based components. However, the components of real earnings management provide less information of future profitability. We observe that the more informative the information content of earnings is, the more precise the prediction of future profitability can be.

Earnings persistence and stock prices: empirical evidence from an emerging market

Purpose – This study aims to investigate the persistence ability of accounting variables, namely, abnormal earnings, book value, accruals and cash flows over a period of time and their valuation relevance in Indian scenario. Design/methodology/approach – The study utilizes the generalized version of the Ohlson model which links market prices with abnormal earnings, book value and earning components (accruals and cash flows). Fixed-effect panel data regression is used to analyze six years of data on the sample units to determine the persistence and valuation relevance. Findings – The findings provide evidence on the construct of persistence and value relevance of earnings and book value of equity in the Indian context. The findings further confirm that investors in India are fixated on earnings and fail to attend separately to the cash flow and accrual components of earnings while undertaking their investment decisions. Practical implications – The empirical findings of the study will enable the analysts and investors to understand the relevance and persistence of accounting variables in case of an emerging market like India. Originality/value – The study extends the extant literature on value relevance studies in developed markets to an emerging market like India and enriches it in several ways.

The Incremental Information Content of the Cash Flow Statement: An Australian Empirical Investigation

The general objective of the present study is to investigate and assess the incremental information content of cash flow disclosures as required by the AASB 1026 “Statement of Cash Flows”. This test addresses the issue of whether a change in cash flow components has the same relationship with security prices as that in earnings. Several previous studies indicate both income and cash flow statements may be mutually exclusive or mutually inclusive statements.The data to test three hypotheses came from companies listed on the Australian Stock Exchange for the period of 1992 to 1997, a subsequent period of the requirement to apply AASB 1026. General results from hypothesis tests indicate that cash flows have information content more than that provided by earnings alone and that cash flows have relative information content, given earnings alone. This finding suggests that the cash flow statement and the income statement provide mutually exclusive information. This finding refutes results of previous studies from the USA and UK that indicated cash flow data had less information value than that conveyed by earnings. Other implications and suggestion for further study are also discussed in the paper.

Audit quality and market pricing of earnings and earnings components in China

Purpose – The purpose of this paper is to investigate the effect of audit quality on the market pricing of earnings and earnings components in China. Design/methodology/approach – The paper measures audit quality using three tiers of audit firm designation, namely International Big 4 audit firms, local Top 10 audit firms and, finally, the local second-tier audit firms. Earnings are decomposed into accruals and cash flow components and accruals are further decomposed into discretionary and non-discretionary accruals. Findings – The paper finds that, although earnings and its components are priced positively by the Chinese stock market, Big 4 audit does not provide any incremental benefit to clients in terms of market pricing of clients’ financial numbers. The paper finds a negative impact of local Top10 audit on the pricing of earnings in China. However, the paper finds no incremental effect of local Top 10 audit on the market pricing of earnings components. Originality/value – Although prior research in China has used modified audit opinion as the audit quality matrix, the paper considers market valuation of earnings and earnings components for firms audited by different categories of auditors.

A POSSIBILISTIC APPROACH TO CALCULATING THE INTERNAL RATE OF RETURN FOR INVESTMENT PROJECTS WITH FUZZY CASH FLOWS

The internal rate of return (IRR) is among the most widely used characteristics of investment projects. In the deterministic case the IRR can be found as a solution to an algebraic equation. The existence and applicability of the IRR may be guaranteed by rather general conditions, e. g. those of Norstrom theorem. Under uncertainty, the IRR ceases to be uniquely determined even for typical projects (a project is typical if costs precede returns). Under uncertainty, the IRR can take values from a more or less large set of possible values. A key problem is to transform the information about initial parameters into a distribution of the IRR values. Probabilistic methods can be used if quite a number of stringent requirements are met. If an unusual or extraordinary project is considered the probabilistic approach is not sufficiently substantiated. In such cases possibilistic methods and fuzzy set theory seem to be more suitable. The present paper aims to provide a method for evaluating the IRR of investment projects with fuzzy cash flows using the possibility theory. Given a fuzzy cash flow, the IRR is presented as a fuzzy set and the membership function may be considered as a version of distribution. Under the standard addition of fuzzy numbers we give explicit formulas for the membership function of the IRR. If components of a fuzzy cash flow are correlated we use the addition of fuzzy numbers with respect to t-norms. Generally, a possibilistic evaluation of the IRR with respect to a non-standard t-norm is rather difficult and was not considered before. If the t-norm is generated by a convex additive generator we reduce the evaluation of the IRR to a common convex optimization problem. A numerical example is presented. We believe the proposed method can be applied to evaluating the efficiency

Determinants of Firm Performance and Growth During Economic Recession: The Case of Central and Eastern European Countries

The crisis has hit the corporate sectors of the new EU member states from Central and Eastern European countries (CEECs) more than those of most old EU member states. Taking full account of firms’ heterogeneity, the paper analyses what kind of CEECs firms’ characteristics make some of them more resilient to crisis than the others. Using panel VAR system on a large firm-level dataset we estimate the responses of firms’ employment and investment to cyclical demand shocks and financial shocks. Controlling for industry, time and country differences, we split firms according to size, age, export status, foreign versus domestic ownership and pre- vs. during crisis growth in order to compare firms’ responses between distinct splits. We find that cyclical drop in demand decreases firms’ employment in subsequent periods but there is substantial heterogeneity among different types of firms. Old and especially small old firms react more swiftly, whereas downward adjustment in employment is less severe in exporters and in foreign-owned firms. On the other hand, investment does not respond to demand shocks per se, but to free cash flow component of the business cycle. It is large young firms that are the most and small young firms that are the least responsive to financial shocks in terms of investment activity. In contrast to employment adjustments, exporters adjust their investment activity to cash flow availability to a larger extent than non-exporters. Differences in country specific settings also show important impact on firms’ resistance to crisis. The quality of legal institutional environment in a country is positively correlated with the employment sensitivity to shocks but it has no discernible effect on investment sensitivity. On the other hand, political and economic institutions make employment more stable over the cycle.

Earnings Volatility and Earnings Prediction: Analysis and UK Evidence

This paper confirms that US evidence of a negative relationship between earnings persistence and earnings volatility applies to UK firms over the period 1991–2010. Our analytical framework highlights the possibility that this result may reflect downward estimation bias in earnings persistence (and persistence of cash flow and accruals components of earnings) related to transitory earnings elements. Out-of-sample forecasts, based on models estimated for earnings volatility quartiles, suggest significant improvement in earnings forecasts for lower volatility firms. The results also suggest that the negative association between earnings persistence and volatility may be due to both estimation bias and variation in core earnings persistence.

Cash-Flow or Discount-Rate Risk? Evidence from the Cross Section of Present Values

Realized returns comprise (ex-ante) expected returns plus (ex-post) innovations, and consequently both expected returns and returns innovations can be broken down into components reflecting fluctuations in cash flow (CF) and discount rate (DR). I use a present-value model to identify the CF and DR risk factors which are latent from the time series and cross sections of price-dividend ratios. This setup accommodates models where CF risk dominates, like Bansal and Yaron (2004), and models where DR risk dominates, like Campbell and Cochrane (1999). I estimate the model on portfolios, which capture several of the most common cross-sectional anomalies, and decompose the expected and unexpected returns into CF and DR components along both time-series and cross-sectional dimensions. I find that (1) the DR risk is more likely to explain the variations of expected returns, (2) the CF risk drives the variations of unexpected returns, and (3) together they account for over 80% of the cross-sectional variance of the average stock returns.

Cash Flow Statement as an Evidence for Financial Distress

In this study, the effect of cash flow components on financial distress score is examined for 124 companies selected from Istanbul Stock Exchange (ISE). It is further analyzed whether cash flow components have an explanatory effect on bankruptcy risk and financial health of companies. Four separate models are constituted and Linear Regression Model is used to evaluate company age, company size, cash flow from operations (CFO), cash flow from investing (CFI) and cash flow from financing (CFF) activities as a function of financial distress score of companies. The results show that there is a negative relationship between CFO, company size and financial distress score of companies. On the contrary, CFF is observed to be positively related with the financial distress score. Meanwhile, it is further observed that the standardized coefficient of CFI is statistically insignificant and hence it does not provide any evidence for the financial weakness or bankruptcy risk of companies.

Regional Economic Activity and Stock Returns

This study analyzes the link between regional economic conditions and stock returns. I identify all U.S. states that are economically relevant for a company through textual analysis of annual reports and find that forecasts on economic conditions of company-relevant U.S. regions positively predict stock returns. Information arising from all relevant states matters over and above the information content of the mere headquarter state. These forecasts also predict firms' real operations, suggesting that regional conditions capture an important cash flow component of stock returns. Finally, the gradual diffusion of this information is slower among difficult-to-arbitrage firms.

Corporate Sustainable Growth and the Financing of Innovation

R&D investments are a channel for growth, at the macro and micro levels. However, they are known to be characterized with high adjustment costs, therefore, it is generally admitted in the literature that firms try to smooth their R&D investments in face of shocks to internal finance, and the literature supposes that the observed investment – current cash-flow sensitivities are downward biased because R&D expenses are expected to respond to the permanent component of cash-flow but not to its transitory component. However, very few proofs, if at all, exist on the link between R&D and cash-flow components and its implications in terms of its contribution to the corporate sustainable growth. The authors decompose cash-flow into its permanent and transitory components and provide formal evidence that R&D- current cash-flow sensitivity is downward biased and that R&D- permanent cash-flow sensitivity better informs about the contribution of cash-flow to R&D smoothing, which shows a managerial commitment to sustainability. Unexpectedly, and in spite of the negligible observed sensitivities of R&D to the transitory component of cash-flow, the authors’ regressions reveal that these sensitivities have an asymmetric pattern: they are higher when cash-flow is expanding than when it is declining. This reveals a managerial preference for immediate growth, which jeopardizes sustainable growth, because of the risk of costly liquidation inherent to the reliance on the volatile transitory cash-flows.

The Value Relevance of Direct Cash Flows Under IFRS

This study examines if there has been a change in the value relevance of direct cash flow components since the adoption of International Financial Reporting Standards (IFRS) in Australia. Our results show that for both industrial and extractive firms direct cash flow statements are value relevant under Australian Generally Accepted Accounting Principles (AGAAP) and remain so after the adoption of IFRS. In addition, for industrial firms there is a significant increase in the value relevance of direct cash flows after IFRS, along with an increase in the value relevance of accruals. These results are consistent with the proposition that direct cash flows play a reinforcing role that complements the more complex IFRS accounts. Consequently, if the International Accounting Standards Board (IASB) were to mandate direct cash flow statements it would, in all likelihood, provide users of accounts with a valuable incremental source of hard transaction information.

Analysis on Investment Risk of Hydropower Project

Pre-estimate of hydropower project investment risks is of much importance because of the huge economic loss caused by the negative effects of the risk factors. Components of cash flow of hydropower project investment and finance evaluation are presented to study the effect of investment risk variables on hydropower project based on the structure of hydropower project investment and benefits. The project investment risk and index are evaluated by the simulation technique, which provides a basis for scientific decision-making of the project.

The Value Relevance of Direct Cash Flows under International Financial Reporting Standards

This study examines if there has been a change in the value relevance of direct cash flow components since the adoption of International Financial Reporting Standards (IFRS) in Australia. Our results show that for both industrial and extractive firms direct cash flow statements are value relevant under Australian Generally Accepted Accounting Principles (AGAAP) and remain so after the adoption of IFRS. In addition, for industrial firms there is a significant increase in the value relevance of direct cash flows after IFRS, along with an increase in the value relevance of accruals. These results are consistent with the proposition that direct cash flows play a reinforcing role that complements the more complex IFRS accounts. Consequently, if the International Accounting Standards Board (IASB) were to mandate direct cash flow statements it would, in all likelihood, provide users of accounts with a valuable incremental source of hard transaction information.

Regulation FD and analysts’ vs. investors’ weightings of the cash components of earnings

This paper investigates whether investors’ bias in processing the information contained in the cash components of annual earnings has been reduced, and whether the difference in bias between financial analysts and investors has decreased subsequent to Regulation Fair Disclosure (hereafter, Reg FD). We compare analysts’ and investors’ weightings of the three cash flow components of earnings, defined by Dechow, Richardson, and Sloan (2008), from 1985 to 2008, using historical weightings as benchmarks. Our results show that, in the post Reg FD period, the magnitude of investors’ (analysts’) mis-weightings has decreased (increased), and the differences between analysts’ and investors’ mis-weightings have become smaller. Overall, these results suggest that financial analysts’ information advantages over investors declined after Reg FD took effect, and that investors consequently are less biased in assessing the persistence of the cash flow components of earnings following the implementation of Reg FD.

A study on effects of cash flow patterns and auditors’ opinions in predicting financial distress

Article history: Received May 12, 2013 Received in revised format 25 June 2013 Accepted 27 June 2013 Available online June 29 2013 Bankruptcy has been one of the most important issues among investors in stock market and there are literally different techniques for predicting bankruptcy. In this paper, we study on effects of cash flow patterns and auditors’ opinions in predicting financial distress on some 80 selected firms traded on Tehran Stock Exchange over the period 2005-2011. In this study, the combination of cash flow patterns represent firm’s resource allocations and operational capabilities interacted with their strategy choices. In additions, predictions about each individual cash flow components, operational, investment, financial, are derived from economic theory, which forms a basis for the life proxy. We use cash flow patterns in the decline stage and compare the results with auditors’ opinions. The results indicate that cash flow patterns could predict financial distress companies in Iran. In addition, the effective cash flow patterns in predicting financial distress is more than auditors’ feedbacks. © 2013 Growing Science Ltd. All rights reserved.

What Drives Market Return Predictability?

Market return predictability may be driven by time varying discount rates or changing beliefs of cash flow. We use analyst earnings forecast to separate cash flow and discount rate components of returns and distinguish the source of return predictability by a set of predictive variables commonly used in the literature. The overall evidence is consistent with the idea that the predictive variables capture time varying discount rates. Some variables also predict cash flow component of returns, implying that these predictive variables may capture investors' biases in projecting aggregate future cash flows.

Dividends and Share Repurchases

The share value is the present value of the expected equity cash flows, and the two main components of equity cash flows are dividends and share repurchases. We focus on the evolution of dividends and share repurchases on the U.S. stock market, although we also provide some data about other countries. We show the evolution of the dividend yield of GE, Boeing and Coca-Cola. We compare the evolution of the yield on 30-year Government bonds and the dividend yield in the United States. Both yields have fallen in the last 30 years. We compare the evolution of the dividends per share of Coca-Cola and Pepsico with the earnings per share, and we calculate the expected dividend growth of Coca-Cola and Pepsico implicit in the market prices.