Both cash flow and earnings are important indicators of the well-being of a company. But which of the two is the leading indicator?
Investors often hear analysts and money managers argue that cash flow is a more useful metric of investment attractiveness than earnings. If you compare earnings with cash flow figures as measures of performance, it raises several questions.
Why do earnings and cash flow differ from one another?
In a very simple business, a firm receives revenue by selling some type of goods or services. The difference between what it gets by selling its goods or services and whatever cost it incurs to provide them is the net earnings for the firm. If the firm receives cash payment as and when it makes sales and immediately pays cash for its costs, its earnings and cash flow would be the same. But this is not how the real business world works.
Earnings and cash flow vary because of the way accrual accounting treats timing differences between business actions and cash movements:
First, there are often short-term timing differences between when a firm records sales and expenses versus when the firm actually receives and pays out cash.
Second, there are timing differences between a firm's cash outlay for long-lasting assets such as buildings or equipment and when the firm is permitted to expense these assets.
So, Earnings is a number based on the principle of accruals. It is an adjustment of cash flow. The advantage of earnings should be that any noise in the cash flow (which does not reflect underlying economic performance) is eliminated. Examples of this noisy, or temporary, component of cash flow are: exactly when the company receives payment from its debtors; or exactly when it pays its suppliers for deliveries of stock.
Although accrual accounting eliminates this noise from the earnings measure of performance, it is possible that earnings suffer from a problem which cash flows do not, namely manipulation by the management of the company. It is well recognized, in positive accounting theory, that managers may manipulate reported earnings in order to serve their own interests; for example, they may manipulate earnings if they are paid a bonus when earnings reach a particular target level.
It is said that “Profit is an agreed amount arrived at on the basis of considered opinions of senior accountants.” That’s true actually - earnings in a Profit and Loss Account is just a matter of opinion, an accounting concept - it is not a hard real number. Managers may manipulate earnings by making excessive provisions for bad debts in good years in order to reduce earnings to a level just above the target. In subsequent periods, when company performance needs a boost to reach the earnings target, those provisions which have been unused can be released to the profit and loss account, effectively as income.
The Important Issue
Before we consider free cash flows for the valuation of companies given the potential for manipulation of earnings through accounting, an important issue is still there: when earnings and cash flow vary because of the timing differences in business actions and cash movements, one of the two should be a leading indicator in time of the other. The question is "whether cash flows are a more informative measure of future performance than earnings?" To paraphrase it, do the cash flows have the capability to predict earnings in time or is it vice versa?
To use the layman's logic, business, of course, starts with investment. The more cash you have in your hand, the bigger investment you can make initially, thereby generating bigger earnings for you. So it seems the story will always begin with cash flows: the bigger cash flows bigger the earnings. But the question is "is it really so?". Do the cash flows really have the predictive ability to predict the future earnings or is it vice versa?
Let us take a few scenarios:
Imagine a firm which is bloated with fat free cash flows. But when one looks deeper into its accounts, it is found that the firm is not investing in replacing its old capital assets, thereby increasing free cash flows at its disposal. Such rise in cash flows would not result in increase in future earnings because future earnings would suffer as a result of its inability to bring in new capital equipments to replace the old. In this case rise in free cash flows does not drive future earnings.
Imagine another firm that decides to begin offering credit to its customers to encourage them to buy more products. If the firm's move resulted in an increase in sales, it is likely that this would show up as an increase in reported earnings as well. Only cash flow analysis would reveal that the firm's customers had not yet actually paid for the new sales. Lucent Technologies is an example of a company that investors once loved for its steady earnings growth, but investors ignored the fact that Lucent's cash flow was not growing at nearly the same rate as its earnings. Eventually, Lucent's stock price dropped significantly during the tech stock collapse of 2000-2001, in part because the customers to whom it had extended credit were unable to pay for their purchases. The rise in earnings did not result in increase in future cash flows. Earnings do not drive cash flows.
So, the situation seems confusing with no clear picture coming out!
Various studies have also been done on this topic about the predictive ability of cash flow and earnings. I recently came across a study by Bezuidenhout, Hamman and Mlambo at the University of Stellenbosch Business School (USB). It also investigated this intriguing question of causality between cash flow and profitability, but with contradictory results. The overall findings were mixed. It could not be established beyond doubt whether earnings cause cash flows, or vice versa.
So, the chicken & egg story remains as it is: Which came first? But the comfort can be drawn from the fact that in the long run these two measures must converge, since earnings and cash flow differences stem from timing. However, over shorter time periods, the degree to which they differ provides the financial analysts with critical information about the nature of a firm's operations.
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