An Analysis Of The Comparative Predictive Abilities Of Operating Cash Flows, Earnings, And Sales

Abstract

<p class="MsoBodyText" style="text-align: justify; margin: 0in 34.2pt 0pt 0.5in;"><span style="color: black; font-size: 10pt;"><span style="font-family: Times New Roman;">Prior studies (e.g., Greenburg et al., 1986; Murdoch and Krause, 1989) provide evidence that earnings outperforms historical cash flows in predicting future cash flows. Later research (e.g., Barth et al., 2001) demonstrates that the major accrual components of earnings each possess significant explanatory power in predicting future cash flows and that they augment, rather than replace, the predictive ability of aggregate earnings.<span style="mso-spacerun: yes;">  </span>The current study furthers this work by examining the predictive power of another major component of earnings, i.e., sales.<span style="mso-spacerun: yes;">  </span>Using share price as the dependent variable and as a proxy for future cash flows, this study compares the predictive abilities of changes in operating cash flows, earnings, and sales.<span style="mso-spacerun: yes;">  </span>Similar to the findings in prior research, earnings predicts better than operating cash flows.<span style="mso-spacerun: yes;">  </span>More importantly, however, sales predicts with greater accuracy than either operating cash flows or earnings.</span></span></p>

The Review of Literature on the Role of Earnings, Cash Flows and Accruals in Predicting of Future Cash Flow

“…Many studies concluded that working capital from operations and net income before extraordinary items and discontinued operations plus depreciation and amortization are powerful than other cash flow measures (Arnold, Clubb, Manson & Wearing, 1991;Quirin, O'Bryan, Wilcox & Berry,1999;Quirin, O'Bryan & Berry,2000) Study by Jordan, Waldron, and Clark (2007) in USA compared ability of cash flow from operations, earnings and sales in predicting future cash flow of 100 companies of the Fortune 1000 companies and finds that sales are a better predictor of future cash flow than cash flow from operations and earnings.…”

The Comparative Predictive Abilities Of Accrual Earnings And Cash Flows In Periods Of Economic Turbulence: The Case Of The IT Bubble

“…One major decision in the research involves whether to investigate these relationships using a direct or indirect approach. The indirect method uses share prices to proxy for future cash flows (Ball and Brown, 1968;Rayburn, 1986;Wilson, 1986Wilson, , 1987Bowen et al, 1987;Ali, 1994;Dechow, 1994;Cheng et al, 1996;Pfieffer et al, 1998;Jordan et al, 2007). Other researchers (Lipe, 1986;Barth et al, 1992;Barth et al, 1999;Barth et al, 2001) note weaknesses in the share price proxy approach for predicting future cash flows and consequently use the direct approach.…”

Market reaction to the positiveness of annual report narratives

“…Finally, we include the percentage change in sales in our set of regressors. This inclusion is motivated by the findings of Jordan, Waldron, and Clark (2007) who show that sales predict stock prices and Barbee, Mukherji, and Raines (1996) who found that sales yield is one of the strongest determinants of returns.…”