Free Accounting Essays - Cash Flow Statement
A) Do investors actually analyse/consider the cash flow statement when making investment decisions and if not,
B) Have international financial reporting standard setters considered this when implementing IAS7 from 1 January 2005 - bearing in mind that "it is shareholders needs that take priority in deciding on the nature and detailed content of the general purpose reports" (Framework for the preparation and presentation of financial statements IASC, 1989). i.e., What is the IASB doing to research this area and implement the
findings?
Section I - INTRODUCTION
The recent spurt in big accounting standards like Enron and WorldCom has once again brought cash into focus. Internet boom saw investors focusing on potential earnings with little reference to cash flows. The demise of larger companies and scale of manipulation in earnings has once again turned the tide in favour of cash flows.
That the share price is the discounted value of future cash flows should imply investors’ inclination more towards cash flows than any other financial performance measure for investment decision. But in reality, it has been observed that investors’ reaction more in line with changes in net income than changes in cash flows.
The reason that earning multiple is a shortcut method for share price estimation lends credibility to the immediate reaction of share price movement more inclined towards change in earnings than change in cash flows. The rapid flow of information now a day puts more pressure on investors to react quickly to information content of financial results. It takes time to analyse cash flow statements and model it for discounted value of future cash flows. It is easier and faster to use to earning multiple.
Many researches conducted over the years have shown that share prices react more to earnings in short term and more to cash flows in the long term. Share price, especially of companies facing financial distress, react sharply at signs of cash crunch. But reaction to changes in cash flow takes time as compared to immediate reaction to earnings. So probably the immediate reaction is based on earning multiple but medium to long term price reaction after results declaration is based on cash flow statement.
But the recent stock market bust and failure of large corporations have made investors look more at tangible cash flows. International Accounting Standards Board (IASB) also mentioned that more and more investors are looking at non-income measures for financial analysis.
This research is undertaken to analyse whether investment decisions are still based more on net income than cash flows. We have used net cash flow from operations as a measure of cash flow because it has higher predictability in generating future cash flows. The paper analyses the abnormal share price returns on the day of result announcement and five days after it with respect to changes in net income and net cash flow from operations. Five day period is taken as a medium period for investors to analyse and implement the information content of cash flows statements.
We found that the correlation in percent change in net income and net cash flow from operations is less. This means cash flow statements have additional information content and investors should pay attention to them. We then correlate abnormal share price returns with the direction of movement in net income and net cash flow from operations. The result was strongly in favour of cash flows on the day of result announcement and it was mixed the over five day period. Share prices increased with increase in cash flows. It is probably because market has already priced in earnings change at the time of trading statement and so information content of cash flow is higher than net income.
But when we did the regression analysis of abnormal returns with net income and cash flows, the results showed that net income has higher correlation with abnormal returns. And also the coefficient was negative, though very less in magnitude, meaning that share price decreased with increase in net income. This was probably due to some of the companies had extremely high negative net income percent change and distorted the whole result.
We also analysed the investors’ reaction to quality of earnings by relating the abnormal price returns with change in ratio of net cash from operations to net income. Most of the companies showed positive abnormal returns on the day of result announcement with increase in net cash flows from operations to net income ratio.
In light of divergent results under different methods, we can’t prove conclusively whether investors put more focus on net income or net cash flows from operations in investment decision making. The paper also highlights the shortcomings in the approach adopted to analyse investors’ preferences for investment decision making. Yet it is clear that investors don’t react mainly to earnings change on the day of results announcement.
This paper will strengthen the view that investors have started looking beyond just earnings for basing their investment decision. It will also show that information is assimilated and analysed very quickly now a day.
IASB is also trying to format financial statements that allow investors to do more meaningful financial analysis. The paper also looks at the changes introduced by IASB to help investors look more at cash flow statement.
The rest of the paper is divided into the following sections. Section II is on literature review. Section III describes the methodology of this paper. Section IV is on data collection, analysis and interpretations. Section V deals with what IASB is doing about improving usefulness of financial statements with respect to cash flows. The paper concludes with section VI.
Section II – LITERATURE REVIEW
Most commonly used scientific method for valuation of a firm – discounted cash flow method – depends on the expected future cash flows of the firm. This is one of the major foundations of the financial theory. Discounted cash flows models are the cornerstone of the financial theory. Cash flows offer more credibility to valuation as they are more tangible than accrued earnings. ‘Historical cash flow information gives an indication of the relationship between profitability and cash-generating ability, and thus of the quality of the profit earned’ (Accounting Standards, 2004). Other methods are based on earning multiples, but they are normally seen as a shortcut rather than a methodical approach.
Differential share price reaction to earnings and cash flow has always fascinated academicians and a larger number of studies have been done on this topic. Ball and Brown (1968) did one of the earliest studies on the information content of earnings and showed that there is a positive association between stock returns and earnings. Investors’ fixation on earnings is attributed to earnings’ ability to summarise financial performance.
This is all the more interesting when we know, more in light of recent accounting scandals, that earnings can easily be manipulated. Cash flows on the other hand offer very less scope for manipulation and hence should have more credibility. So investors should rely more on cash flows than earnings per share for deciding share price. But the anecdotal evidence doesn’t point towards this. It is all the more evident when we see earnings per share all round but very rarely see cash flow per share. All price multiples are expressed in terms of earnings rather than cash flows.
One strong argument in favour of earnings is that earnings, though subject to manipulations, reflect future cash flows. As share prices reflect future more than past, the higher ability of earnings to project future cash flows lends it more useful in share price calculation. And we have seen more cases where high earnings of past haven’t delivered higher cash flows in future.
Let us also look at some of the reasons for difference between earning and cash flows.
1. Depreciation. Depreciation is a non-cash item. It may result in different degree of change in earning and cash flow as depreciation on a fixed asset is based on its historic cost whereas the earnings on that asset vary with market price. This aspect is more pronounced in case of real estate investment trusts. Graham (2000) pointed out that depreciation results in substantial difference between earnings and cash flows for equity Real Estate Investment Trusts and there is strong chance that the gap will increase over time.
2. Higher amount of accounts receivables. Many times companies go for hard sell near the financial closing to increase their earnings. They sell abnormally higher amounts of stock to their distributors. The company is merely shifting inventory from the corporate level to its customers. The high amount of inventory level with distributors would affect company’s sale in coming months.
3. Higher levels of inventory. The earnings may be higher because company has spent a large amount of cash in building inventory. Above normal levels of inventory may lead to write-offs in future. It also means that if company reduces its inventory levels over time, then cash flow might be more than earnings.
4. Revenue recognition. Firms may use different methods of revenue recognition that result in future earnings booked in the current year. This was a common practice during the last internet boom. This obviously increased earnings substantially without a corresponding change in cash flows.
The above points can result in significant differences between earnings and net cash flows. Since it is discounted value of cash flows that determines the value of a firm, investors should focus more on cash flows than earnings.
Many studies have found the fixation of investors on earnings as compared to on cash flows. In a prominent study by Sloan (1996), he found that stock price behaviour more in line with movement in earnings and not fully reflecting the informational content of cash flows and this to remain until the cash flow information has a significant impact on future earnings. He showed that informational content of accrual and cash flow components of earnings is systematically different, but is not reflected in the share prices. It strengthens the case that investors don’t pay due attention to cash flow statements.
Investors don’t focus fully on cash flows as long as earnings are stable or growing. Only when a company starts showing signs of distress the investors flock to cash flow statements. The above findings are observed many times in the market and especially when companies in financial distress go to market for raising funds.
Sloan’s study was supported by Pfeiffer and Elgers (1999). They found that only multiyear correction of past mispricing shows significant valuation differences for operating cash flows, relative to accruals component of earnings. They were able to detect reliable valuation differences for the cash and current accrual components of earnings.
The study by Sloan (1996) also showed an interesting but often ignored information content of results that earnings performance attributable to the accrual content of the earnings is less likely to persist over time as compared the earnings performance attributable to the cash flow components of the earnings. This shows the superiority of cash flow earnings compared to accrual earnings over longer term. The firms which have a high component of earnings in terms of accruals are more likely to show a negative future abnormal share returns.
Sloan (1996) also said that such higher negative abnormal returns are more concentrated around future earnings announcements. This is supported by the logic that companies now a day normally announce bad results and cash injection requests at the same time. Such companies, while announcing results, either propose terms and conditions of share placing or they indicate of result their intention to shortly raise additional capital to meet working capital requirements.
When Sloan (1996) did the time series analysis of firms with varying levels of accrual earnings, the results showed the lower persistence of earnings performance attributable to the accrual component of earnings relative to earnings performance attributable to the cash flow component of earnings. This highlights the fact that it is difficult to sustain accrual earnings over time and investors should take this into account when making an investment decision.
In Sloan’s (1996) time series analysis, the future earnings had a higher coefficient for cash flows and a lower coefficient for accrual earnings. This clearly shows that cash flow have superiority over accruals when projecting future earnings and so should be reflected in stock prices. Stock prices should move more in line with changes in cash flows than in response to accrual earnings. But he found the opposite results. The share returns responded more to the accrual component of earnings as compared to the cash flow component. Sloan’s results confirm investors’ fixation on accrual earnings. Investors place more faith on accrual component in determining future earning potential and relatively lower emphasis on cash flow component.
Houge and Loughran (2000) also found the evidence of investors’ fixation on earnings. According to them firms with high accruals components in earnings are more likely to have managed their earnings. Since investors are fixated on investors, they overvalue such companies. This means that investors reward management for earning management. Within their focus period of observation, Houge and Loughran (2000) showed that a long position in the high earnings quality portfolio along with an equal short position in the low earnings quality portfolio would generate an excess return of about 16 per cent per year. This is a high return and demonstrates that investors fail to account for the underlying quality of earnings.
On the other hand, some of the researchers showed that market do give preference to cash flows. Wilson (1987) concluded that for a given amount of earnings, the market reacts more favourably for stocks with higher amounts of cash flows. Wilson’s study was based on analysis of price movements in the 9 day period after publication of annual reports. Rayburn (1986) couldn’t found out a significant difference in the market response to cash flows and current accruals.
Wilson’s study was based on results declared in 1981 and 1982. But when Bernard and Stober (1989) extended Wilson’s study to 1977-1984, they could not obtain similar results for the overall period. This possibly conveys that results obtained by Wilson were due to some other things occurring at that particular time and are not observed in longer durations.
Bernard and Stober (1989) also failed to find a systematic difference between the implications of cash flows and accruals on share price movement at the time of release of results. They could think of two possible answers for the above behaviour. First, the differential information content of cash flows and accrual components are highly contextual and it is very difficult to model them. Second, most of the companies release trading statements before they release annual results and so much of the price movement has already occurred before results announcements.
The first point raised by Bernard and Stober (1989) mirrors human behaviour. Investors take a cautious approach during economic downturns and look for tangible earnings in hand than accrual earnings. It is expected that during economic downturns investors would react more favourably to cash flows than in economic booms. Wilson (1986) noted that his period of study, 1981-82, was a period of economic downturn. Managements try to reduce working capital during downturns and market reacted favourably to management’s efficiency. This then manifests as a preference of cash flows component of earnings over current accruals component of earnings. Under such complexities of economic conditions and different drivers of cash flows, it is difficult to model investors’ reaction to differential component of cash flows and accrual earnings over a short period.
Trading statements released by companies give a very close approximation of earnings by saying whether company would meet or not the market expectations. Market quickly incorporates that information into share price. Some trading statements do give net debt figure but no information is available about cash and accrual components of earnings. So whether share price returns around annual result announcements are due to earnings or mainly due to cash flows only is difficult to segregate.
The importance of analysing cash components of earnings in estimating the future earnings for valuation purpose has been emphasised in a large number of researches and academic papers. Graham et al. (1962) recommended a five-step process for estimating the future earnings from current earnings. They adjust current earnings to various subjective operating accruals like reserves, depreciation and inventory. Companies can adopt numerous ways of estimating these depending on their requirements and these accruals have lower probability of recurring in future. High earnings performance that is attributable to the cash flow component of earning is more likely to persist than the one attributable to the accrual component of earnings.
Bernstein (1993, 461) states that ‘CFO (cash flow from operations), as a measure of performance, is less subject to distortion than is the net income figure. This is so because the accrual system, which produces the income number, relies on accruals, deferrals, allocations and valuations, all of which involve higher degrees of subjectivity than what enters the determination of CFO.’
Analysts and investors faith in cash flow than earnings has been strengthened further after the recent spate of big accounting scandals. A measure of robustness of earnings is the ratio of cash flow from operations to net income. The higher the ratio of cash flow from operations to net income, the higher the quality of those earnings. Companies reporting higher levels of mismatch between earnings and cash flow would probably be using suspicious income recognition or expense accrual criteria. So an analyst or an investor should always calculate cash flow from operations to net income ratio to check the quality of earnings.
Many studies have shown that operating cash flows have higher market valuations than do aggregate accruals (Cheng, Liu and Schaefer [1996]). This is also supported by human behaviour to feel more comfortable about “bird in hand than two in the bush”. Other things being equal, earnings backed up by cash flows are of a higher quality than those that are not. This supports the argument that earnings can be manipulated more easily than cash flows. But whether this should imply higher focus on cash flows than on earnings is still a question.
The aim of this study is to analyse whether investors focus more on earnings or on cash flow when making investment decisions. This study tests the hypothesis that the earnings expectations visible in share price returns fail to reflect the higher earnings persistence attributable to the cash flow component of earnings. Hypothesis will be confirmed if simultaneous increase in profits and decrease in cash flows will increase share price or simultaneous decrease in profits and increase in cash flows will decrease share price. If investors are fixated on earnings then they will tend to overprice those stocks in which the accrual component is relatively high. Similarly investors will under price stocks that have relatively low levels of accrual earnings.
Much of the above research, while often estimating regression equations, in fact reports correlation rather than tests of specified models. These correlations have added to our descriptive knowledge but have not confirmed or rejected the informational content of accrual earnings and cash flows in valuation.
But it appears that investors are now focusing more on cash flow statements. In a recent note by IASCF, the accounting body said ‘Increased pro forma reporting and other evidence suggests that the use of and reliance on current subtotals and totals (such as net income) as indicators of performance is decreasing’ (IASCF, 2004).
Section III - METHODOLOGY
This study looks at whether investors are more focused on earnings than cash flows when making investment decisions. Investment decisions can be fully reflected through share price movement.
The aim of this study is to observe and analyse the share price movement with respect to earnings and cash flows. Many studies have been conducted on the long-term differential reaction of share price to the information content of earnings and cash flows. This study analyses the differential investor reaction to earning and cash flow at and near result announcement.
Net cash flow from operations is used as proxy for cash flows. Total cash flows also include cash flows from investments and financing. But out of the above three categories, net cash flows from operations have the highest predictive value. Some companies may show large change in cash flows from investments and financing in one year which may not be repeated over time. So it is better to use net cash flows from operations for the purpose of this study.
Before we analyse share price returns around result announcement dates, we will find the correlation between change in net income and net cash flow from operations. If the correlation is very strong, it would mean that the quality of earnings is very high. In that scenario share price movement would be almost same for either net income or net cash flow from operation. There would be no case to carry this research further. But if the correlation is low, it would mean that net income and net cash flow from operations diverge and there is a case to analyse abnormal share price returns with respect to them.
We note share price at the close of one day before results announcement, on the day of results announcement and five days after it. We then compute percent change in share price on the day and five days after results announcement with respect to the price at close of a day before results announcement.
The reason for short duration around result announcement is two fold. First, it helps in understanding investor reaction at the time of announcement. Investors are now under more pressure to react to result announcements as soon as possible. The widespread use of modern communication has resulted in easy and rapid access to information. Investors believe that if they don’t react fast, they may lose out on the opportunity.
Normally such fast price reaction would be based on earnings as it takes time to do proper cash flow analysis. Also not all investors are well versed with cash flow analysis but almost all understand earnings per share. So if share price movement at result announcement is more in line with earnings than with cash flows, it would indicate that investors rely more on earnings than on cash flows for making investment decisions. And such reaction would probably be over by the end of result announcement day.
And reason for analysing after five days of results announcement is that full results are now easily accessible over internet and investors need not wait long to receive postal results. Though it is not possible for all investors to do cash flow analysis during the market open hours on the day of result announcement due to their other engagements, any serious investor would be able to do cash flow analysis over a five day period. Hence a five day abnormal return would be useful to analyse the informational content of cash flow statement.
The view that all information is not absorbed on the day of result announcement was also supported by Morse (1981). His research showed that there are significant trading volumes and price changes in days following the announcement. He suggested that there might be several days of adjusting prices and portfolios.
Ideally it would be useful to use as large database and potentially whole market to conduct the study. But due to time and resource limitation, we would focus on one sector only. We would analyse the abnormal share price movements on the day of result announcements and four days after it.
For companies within the sector we have analysed share price reaction at the time of full year results only. Many companies don’t disclose full statements at the time of half year results and it is difficult for investors to analyse earnings with respect to accrual and cash flow components.
We record full year net income and net cash flow from operations for the latest and previous years. Annual percent change in net income and cash flow from operations is then calculated to see if there is any difference in their trends. If percent changes in net income and cash flows from operations are moving in opposite directions or if the net income and net cash flow from operations percentages are moving in the same direction but the difference is large, investors would probably find additional useful information in cash flow statements. Only if both are moving in same direction and the percentage difference is also small, then it is unlikely that cash flow component will have significant informational content.
For each company, we have also recorded the closing share price on the day of result, before the result and four days after the result. Share price changes are then calculated in percentages on the day of result announcement and four days after it with respect to the share price on the day before result announcement.
We would also record the sector index levels on all the above dates and calculate percentage movements in the sector index.
The abnormal share price movement is then calculated by subtracting sector index movement from the share price movement over the respective period. We calculate abnormal share price returns on the day of announcement and five days after it.
We then carried out a series of regression analysis to establish the relationship between changes in net income and net cash flows from operations on abnormal share price returns. First regression analysis is between percentage change in net income and percentage change in cash flow to observe their correlation.
Second regression analysis is between percentage change in net income and abnormal share price returns on the day of result announcement. Then we perform a regression analysis between percentage change in net cash flow from operations and abnormal share price returns on the day of result announcement. If net income change has higher correlation with abnormal share price movement, then it would indicate investors’ more emphasis on earnings than on cash flow.
The above set of regression analysis is then performed with respect to five day abnormal share price returns. If in this set, net income change has higher correlation compared to net cash flow from operations than it strengthens the belief that investors are more focused on earnings than on cash flows. But if the results show inclination towards cash flows than it is in line with results obtained by Sloan (1996) and Pfeiffer and Elger (1999) that over longer period investors look at cash flows to make investment decision.
Another way of checking whether investors are paying attention to cash flows in decision making is to analyse cash flow to net income ratio. As stated previously, higher ratio of cash flow from operations to net income shows the robustness of current earnings and the higher possibility of future earnings. We will calculate the cash flow from operations to net income ratio for latest and previous year results. Investors’ realisation of higher quality of earnings would be tested through five days and same day abnormal returns.
Section IV - DATA ANALYSIS AND INTERPRETATION
We have selected ‘Health’ sector for analysis. 20 companies were randomly selected from within the sector for observing investors focus on accrual earnings and cash flows.
First annual results data on net income and net operating cash flow data was collected fro each of the company. Annexure I show the net income and cash flow over two years for the selected 20 companies. It also shows the percentage change over a year.
The correlation between percentage change in net income and percentage change in net cash flows from operations is 0.318. The correlation between percent change in net income and percent change in cash flows from operations is positive meaning that increase in one lead to increase in other. But the correlation is not very high meaning that there is divergence not only in absolute changes in net income and cash flows from operations but also in per cent changes in them. It strengthens the view that investors should look at cash flow separately and shouldn’t base their investment decision on earnings only.
The share returns are calculated on the day of result announcement and 5 days after the results. Annexure II shows the share price of each company on the day of result, one day before and five days after the results. Health index is also shown for the corresponding days for all the companies.
Share price percent change on the day of result announcement and five days after it are calculated and so are the ‘Health’ sector index percent changes. Abnormal percent returns for each company are calculated by subtracting index returns from individual share returns.
Annexure III shows the correlation between change in net income and cash flows with abnormal perent returns. The simplest way of finding the correlation is to see how share price moves with respect to change in earnings and net income. We look for companies with opposite movement in net income and cash flows - increase in profits and decrease in cash flows or decrease in net income and increase in cash flows.
6 out of 20 companies qualify under the above criteria – 5 with decreasing net income and increasing cash flows and 1 with increasing net income and decreasing cash flows.
In case of five companies with decreasing net income and increasing cash flows, all five companies showed positive abnormal share price returns on the day of result announcement. None of these companies showed negative abnormal share price return. When we look at 5 days returns after result announcement, the abnormal share price returns were almost evenly spread. Share price of 3 companies showed positive abnormal returns whereas share price of other 2 companies showed negative abnormal returns.
The results are different from our hypothesis that investors pay more attention to earnings as compared to cash flows when making investment decisions. The fact that 5 out of 5 companies showed positive abnormal share return when net income decreased and cash flows increased shows that investment decision was based more on cash flows than on net income on the day of results announcement.
In case of one company with positive movement in net income and negative movement in net cash flow form operations, the abnormal returns on the day of result announcement and five day period were positive and negative respectively.
The above result is in line with Wilson’s (1987) findings that investors pay more attention to cash flows than to earnings. One interesting thing to note is that Wilson did his study during economic downturn. He noted that his results could have been shaped by the economic environment. Investors are more cautious during economic downturns and look for quality earnings backed by cash flows.
Our study incorporates results declared in the last one year. Though UK is not facing an economic downturn, the internet boom and accounting scandals have made investors realise the importance of cash flows.
The higher abnormal returns for cash flows can also be explained because of pre-results release of trading statement. Companies give a fair idea of their performance in trading statements. Though they don’t specify a number for earnings in the trading statement, they still say whether earnings would be as per market expectations or not. But no such information is given about cash flows unless the company is facing cash crunch and would like to go to market soon to raise additional funds.
So when companies release full results, the unexpected part is more on the cash flow side as compared to the earnings side. Price reaction to earnings is probably already incorporated to a large extent at the release of trading statement. At the time of result announcement, the additional information content in full results is more in case of cash flows than earnings and so we see share price movement more in line with the percent change in cash flow than with the percent change in earnings.
Annexure IV shows the result of regression analysis between percent change in net income and one day abnormal share price returns. R square is 0.256 and so only partially explains to a smaller extent the abnormal variation in share price. The coefficient of net income is -0.007. The negative coefficient shows that increase in net income results in decrease in abnormal returns. This is something interesting because we would expect opposite result. The magnitude of coefficient is less and it may be due to one or two entries which have skewed the results. A larger dataset would probably reveal better results on coefficient.
The regression analysis with cash income shows even weaker linkage. Annexure V shows the result of regression analysis between percent change in net cash flow from operations and one day abnormal share price returns. R square is 0.013 and hence doesn’t explain the abnormal variation in share price. T-stats are also insignificant.
These results are slightly contrasting. When we look at percent movements in net income and cash flows and compare them with one-day abnormal returns, we see that all five companies show abnormal returns in the direction of cash flows and opposite to the movement of net income. But when we do regression analysis, only net income has some influence on the one day abnormal returns, though the coefficient is negative.
Annexure VI is the result of regression analysis between percent change in net income and five day abnormal share price returns. R square is 0.057, even lower than R square for one day abnormal returns. Such low R square doesn’t explain abnormal variation in the share price. T-stats are also not significant.
Annexure VII shows the result of regression analysis between percent change in net operating cash flows income and five day abnormal share price returns. In this case the R square drops down significantly to only 0.00001 and so don’t explain anything of the abnormal variation in share price. T-stats are also not significant.
The above results of regression analysis over five day abnormal returns show that investors take into account most of the financial information on the day of result announcement only. When we just looked at the direction of movement of net income and net cash flows from operations, we see that abnormal returns are more in line with net cash flows from operations. When we do regression analysis, we observe that net income explains more of variability in abnormal returns. So our results don’t point to any conclusive driver of abnormal share price returns at and around result announcement.
Also over five days, we fail to observe any pattern either in terms of direction of movement of net income and net cash from operations or in terms of regression analysis.
Many researchers have showed that over longer term the abnormal movement in share prices is in line with operating cash flows. Our study doesn’t show such outcomes. A strong reason for such deviation is that this study monitored abnormal share price returns for just five days after result announcement. Sloan (1996) pointed out that over multiple years share prices do reflect movement in operating cash flows, especially if a firm faces financial distress. So probably five day period is too short time to observe such results.
Our dataset has only one company where in the last year net income has increased and net cash flow from operations has decreased. In this case both the one-day and five-day abnormal returns were positive. But one data point can’t be generalised and hence we can’t conclusively say that investors are fixated on earnings as compared to cash flows.
We now look at the robustness of the earnings by comparing the movement in ratio of net cash flow from operations to net income with the abnormal returns. Annexure VIII shows the ratio of net cash flows to net income over two years. For this analysis we will take only those companies which had positive net income and positive net cash from operations in both the years. Either of one negative or both negative numbers distorts the ratio analysis and so we have excluded such firms. Nine companies met this criterion and they have been highlighted in annexure VIII.
Out of nine companies short listed above, six companies improved their net cash from operations to net income ratio. 5 out of 6 of those companies showed positive abnormal share price returns on the day of result announcement. And 4 out of 6 companies with improved net cash flows from operation to net income ratio showed positive abnormal share price returns after 5 days period.
Three out of nine companies showed decline in their net cash flows from operations to net income ratio. 2 out of 3 such companies showed negative abnormal share price returns on the day of results announcement and one showed small but positive abnormal returns. On five days return, 1 out of 3 companies showed negative abnormal share price returns and 2 showed positive abnormal share price returns.
On the robustness and quality of earnings parameter, we see abnormal share price returns more in line with net cash flows from operations than with net income. Though we didn’t check whether the improvements in net cash flows from operations to net income ratio were statistically significant or not, the trend seems to be in favour of net cash flows from operations.
Overall the picture is mixed. If we look from the angle of movement of net income and net cash flows from operations, we see that more abnormal share price returns were in line with net cash flows from operations. This was also supported by the change in net cash flow from operation to net income ratio. But when we look from regression analysis, we see that net income explains more of variability in abnormal share price returns, even though the coefficient was negative. The negative coefficient was probably a result of the smaller size of the dataset and very high negative percent changes in net income for few companies.
So though we can’t conclusively point that cash flows are now more important than net income in investment decision making, our results are in line with the observation of International Accounting Standards Committee Foundation that the reliance on net income as indicator of performance is decreasing.
Shortcomings in this study
The study has following shortcomings:
1. Impact of sector. It is a belief that investors’ differential reaction to change in earnings and cash flow may be different for sectors. Some growing sectors like technology attract investors focused on growth of future earnings. Such kind of companies need a significant cash injection in the early stages to enhance future potential. In this case the investors are more likely to tolerate a negative cash flow movement if the earnings are stable.
On the other hand, companies in mature and well established sectors are more likely to see a higher share price reaction in line with cash flow trends. Normally value investors are more concerned about cash flows and they also invest in companies for dividend. Any negative trend in cash flows will be seen as a first sign of future dividend cut or total elimination and investors would sell the shares lowering share price.
2. Size of the company. Small and medium companies are more prone to bankruptcy. It is likely that negative cash flow change may have a more negative impact on share price when investors believe that such negative trend may result in companies going to market for more funds.
Also if a large company declares result, then its share price movement may result in similar movement in the sector index due to its large weightage. Under such circumstances it may be difficult to pinpoint the abnormal change, if any that occurs on same day or even after 5-days. But a share price movement of a smaller company won’t have corresponding percentage reflection in the sector index. We can detect the difference in abnormal changes over same day and also over 5-days period.
3. Future trend announcement. Share prices are a reflection of future performance. Companies give an indicator of future performance at the time of result declaration. If future performance is expected to be quite difference, then share price may move in different direction than what is expected from earnings or cash flow change only. It is difficult to segregate the impact of such future guidance as share price from the impact of results.
4. Capital expenditure. Growing companies have a large amount of capital expenditure and it may result in lower cash flows as compared to earnings. But with investors believing in future potential of the company, the share price may not show corresponding decline. It is difficult to segregate the impact of cash flow change due to potentially beneficial capital expenditure from overall change in cash flow.
5. Cash flow variation due to discontinued operations. Companies disclose the earnings separately from continued and discontinued operations. But when it comes to cash flow statements, they don’t differentiate the previous years’ cash flows into continuing and discontinued operations. In absence of such information, it becomes very difficult for investors to value a company based on the cash flows especially in a yeah when a company has sold a business. As an example, BioCompatibles International sold a substantial part of its business in one year prior to its latest results. Their financial statements clearly demarcate earning from continued and discontinued operations. But their cash flow statement doesn’t show how much of last year’s operational cash flow came from the discontinued operations.
6. Trading statements. Companies release trading statements after the end of financial year but before they publish full results. These trading statements give a high degree of results approximation and as such the share prices have already incorporated a lot of information even before the release of full results. Hence observing abnormal share returns near the release of full results may not give true picture of investors’ preference of earnings or cash flows.
7. New developments with 5 days period. New company specific developments like tie-up or successful clinical results may cause abnormal share price results. This study doesn’t take out the impact of such developments.
It would be interesting to do further research on investors’ reaction by incorporating the abnormal impact of trading statements and additional development within the five days period after the declaration of results. Also a research conducted over a larger dataset would give more robust results.
Section V – IASB AND IMPORTANCE OF CASH FLOW
‘The objective of financial statements, as set out in IASC’s Framework for the Preparation and Presentation of Financial Statements, is to provide information about the financial position, performance, and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions’ (IASC, 1999). This information is contained in both income and cash flow statement.
IASC acknowledged that the key objective of financial reporting is to provide information that is useful in making predictions about the amount and timing of future cash flows (IASC, 1999). The higher the predictive value of financial information, the higher is the usefulness of financial statements. IASC also said that profit or loss figures have little predictive value because they are an aggregate of a large number of dissimilar items like depreciation, exceptional items, etc. These items react differently under different economic conditions.
At the same time, IASB Framework mentioned that traditionally the income statement has been used to report financial performance (IASC, 1999). Our study didn’t give a conclusive proof that whether investors’ make investment decision based on net income or on cash flows. Other researches have also given divided results. Even though we know that cash flows have more persistence than earnings over longer term and so investors should rely more on cash flows than on net income for investment decisions, yet research doesn’t conclusively prove that.
An answer to investors’ apathy towards cash flows could be in the way cash flow statements are presented in financial results. Income statements are easier to follow than cash flow statements. Even unsophisticated investors can easily read and understand earnings per share. It is tougher to understand cash flow statements and further difficult to make sense how much cash was generated for each share. While earning per share is readily available in income statement, cash flow statements don’t show how much cash was generated for each share.
Many investors invest for dividends mainly. Dividend per share is also shown on income statement only. So investors have more reasons to look at income statement than at cash flow statement.
IASB has thought about increasing investors’ responsiveness to various financial performance parameters other than earnings. It set up a committee of accounting member of UK, Germany, Australia, New Zealand and USA to look at reporting of financial performance. This committee looked at the reporting of financial performance.
International Accounting Standards Committee Foundation (IASCF), a part of IASB, has also set up a project on performance reporting. This project will involve discussion with national accounting boards to improve the financial reporting format.
IASB has tried to improve investors’ focus on cash flows statement as a more predicable behaviour of future cash flows in the following ways:
1. Improving the format of cash flow statement.
IASB has implemented three separate categories of cash flows to help investors judge not only the current performance but also the ability of a firm to generate future cash flows. Cash flow statements under IAS 7 format have following sub categories – ‘cash flow from operating activities’, ‘cash flows from investing activities’ and ‘cash flow from financing activities’. This format of IAS cash flow statement suits investors for financial analysis purposes. Analysts and investors can clearly see how much cash is generated through various functions - operations, investment and financing.
Cash flow from operations is the most important thing that investors look for valuing a company as it is what will determine the present value of cash flows most. Cash flow from operations shows the maximum level of cash that can be withdrawn from the business without the benefit of cash inflows from investments or refinancing. Investment and re-financing are secondary to operations, and if a company is not generating net cash inflow from operations then it doesn’t have a bright future. By segregating cash flows from operations from others cash flows, IASB has made it easier for investors to assess the predictability of future cash flows.
A company also needs investment to replace and upgrade machinery and technology. Investors can look at the net cash flow after investing to see whether overall activities yield a positive cash flow or not. They can also check whether past cash outflows on investments have yielded positive benefits for the company or not.
Lastly by looking at cash flow under financing, investors can see how a company’s activities have been funded. It is also useful in predicting claims on future cash flows by providers of capital.
If we look at UK’s Accounting Standards Board FRS on cash flow statement, we would see eight separate categories under cash flow statement. An investor would have to add and subtract them to obtain the clear understanding which otherwise is readily available in IAS. The ease to analyse IAS cash flow formats attracts investors attention and they can quickly analyse.
2. No exemption. UK’s FRS allows cash flow statement exemption to certain companies. Absence of cash flow statements makes financial analysis much more difficult. Since investors can’t compare apple to apple when they have one company with cash flow statement and other company’s results without cash flow statements, they lose interest in cash flow statement as a measure of financial performance. Most investors compare the performance of companies in investment decision making. By legally forcing cash flow statements, IAS makes sure that investors have full financial information for making investment decision.
IASB is also looking at ways to improve the income statement so as to improve the predictability of future cash flows from it. It is discussing the use of just one performance statement for financial performance with the three major components – the result of operating activities, the result of financing and other treasury activities, and other gains and losses. This statement will help investors focus more on those earning segments that will generate future cash flows.
IASB is aware of the shift in investors’ focus toward non income elements of financial performance for evaluating investments. It has taken few steps to make it easier for investors to analyse cash flow statements and is in talks with national accounting boards to initiate few more changes.
Section VI – CONCLUSION
Internet boom saw investors focusing on potential earnings with little reference to cash flows. But the demise of larger companies and scale of manipulation in earnings has once again turned the tide in favour of cash flows. Theoretically share price should be discounted value of cash flows and so investors should pay more attention to cash flow statements.
This research analyses whether investment decisions are still based more on net income than cash flows. We used net cash flow from operations as a measure of cash flow because it has higher predictability in generating future cash flows. Percent changes in net income and net cash flow from operations were correlated with the abnormal share price returns on the day of result announcement and five days after it with respect to changes in net income and net cash flow from operations.
The low correlation in percent change in net income and net cash flow from operations means that investors should pay more attention to cash flow statements. The result of correlation between abnormal share price returns with the direction of movement in net income and net cash flow from operations was strongly in favour of cash flows on the day of result announcement and it was mixed the over five day period. This shows that investors focus on earnings alone is declining. A possible reason could be that companies release trading statements some time before full results announcement. Trading statements contain more information on earnings than on cash flows and so by the time of results announcement most of the earnings information is already priced into share prices.
But when we did the regression analysis of abnormal returns with net income and cash flows, the results showed that net income has higher correlation with abnormal returns. This coupled with a very small but strangely negative coefficient in case of net income could have been due to the smaller size of dataset and few companies with large percent variation in net incomes.
On the issue of quality of earnings, measured by using ratio of cash flows from operations to net income, most of the companies showed positive abnormal returns on the day of result announcement with increase in net cash flows from operations to net income ratio. In light of divergent results under different methods, we can’t prove conclusively whether investors put more focus on net income or net cash flows from operations in investment decision making we can see that investors don’t solely rely on earnings in decision making and cash flow analysis also plays an important part in investment decision.
IASB has also acknowledged the traditionally higher role of earnings in financial analysis and is working towards enhancing the role of cash flows in investment decision making.
Annexure I - Net income and cash flow over two years for the selected 20 companies in the Health sector
S.No. Name Declaration date Net Income, £ m % change Operating Cash Flow, £ m % change
Latest Last year Latest Last year
1 1st Dental Laboratories 09-Mar-05 0.14 -0.34 141% -0.15 -0.13 -15.4%
2 Advanced Medical Solutions Group 16-Mar-05 -0.42 -2.08 80% -0.59 -1.71 65.5%
3 Bespak 07-Jul-04 6.60 2.78 137% 13.22 2.98 343.6%
4 Biocompatibles International 17-Mar-05 0.14 16.00 -99% -8.50 -10.30 17.5%
5 Care U.K. 22-Nov-04 6.80 4.10 66% 18.80 11.00 70.9%
6 Corin Group 05-Apr-05 3.60 3.10 16% 3.99 3.29 21.3%
7 DawMed Systems 21-Dec-04 -0.40 -0.29 -38% -0.38 -0.36 -5.6%
8 Dechra Pharma 07-Sep-04 5.08 3.83 33% 10.57 6.54 61.6%
9 Ferraris Group 09-Nov-04 -10.14 0.92 -1202% 5.62 4.50 24.9%
10 Gyrus Group 16-Mar-05 4.21 6.67 -37% 16.31 12.96 25.8%
11 Huntleigh Technology 16-Mar-05 18.31 14.46 27% 33.36 30.91 7.9%
12 Medisys 08-Dec-04 -1.47 -5.98 75% -0.70 -0.82 14.6%
13 Medical House (The) 23-Sep-04 -2.14 -0.35 -511% -0.32 0.07 -557.1%
14 Isotron 16-Sep-04 5.75 2.15 167% 14.76 13.17 12.1%
15 Nestor Healthcare Group 07-Mar-05 -58.19 9.20 -733% 29.61 24.99 18.5%
16 Smith & Nephew 03-Feb-05 125.20 148.10 -15% 226.60 214.50 5.6%
17 Shiloh 06-May-04 0.20 0.31 -35% 0.14 0.61 -77.0%
18 SSL International 27-May-04 -8.00 82.00 -110% 65.30 87.80 -25.6%
19 Whatman 05-Apr-05 -0.53 -1.88 72% 13.75 8.74 57.3%
20 Zi Medical 05-Apr-04 -0.85 -0.61 -39% -0.65 -0.62 -4.8%
(Source: www.hemscott.com)
Annexure II – Share price, Health sector index and abnormal returns
S.No. Name Share price, p Share price % change Sector index Sector index % change Abnormal % change
5-day Same day Prev. date 5-day 1 day 5-day Same day Prev. date 5-day 1 day 5-day 1 day
1 1st Dental Laboratories 38.50 44.25 44.00 -12.5% 0.6% 3,676.98 3,615.95 3,612.13 1.8% 0.1% -14.3% 0.5%
2 Advanced Medical Solutions Group 9.75 10.50 10.00 -2.5% 5.0% 3,596.49 3,676.98 3,707.24 -3.0% -0.8% 0.5% 5.8%
3 Bespak 505.00 509.00 502.50 0.5% 1.3% 3,723.68 3,693.40 3,698.55 0.7% -0.1% -0.2% 1.4%
4 Biocompatibles International 254.00 277.00 266.00 -4.5% 4.1% 3,608.92 3,699.98 3,676.98 -1.9% 0.6% -2.7% 3.5%
5 Care U.K. 365.50 362.00 350.00 4.4% 3.4% 3,610.81 3,511.98 3,553.26 1.6% -1.2% 2.8% 4.6%
6 Corin Group 330.00 312.50 312.50 5.6% 0.0% 3,621.76 3,504.54 3,443.81 5.2% 1.8% 0.4% -1.8%
7 DawMed Systems 16.00 16.00 15.00 6.7% 6.7% 3,605.07 3,602.32 3,538.13 1.9% 1.8% 4.8% 4.9%
8 Dechra Pharma 150.00 154.00 150.00 0.0% 2.7% 3,325.56 3,332.95 3,335.15 -0.3% -0.1% 0.3% 2.7%
9 Ferraris Group 108.00 114.50 103.50 4.3% 10.6% 3,566.71 3,431.75 3,460.38 3.1% -0.8% 1.3% 11.5%
10 Gyrus Group 246.00 247.50 229.00 7.4% 8.1% 3,596.49 3,676.98 3,707.24 -3.0% -0.8% 10.4% 8.9%
11 Huntleigh Technology 402.00 417.50 436.00 -7.8% -4.2% 3,596.49 3,676.98 3,707.24 -3.0% -0.8% -4.8% -3.4%
12 Medisys 7.25 6.88 6.90 5.1% -0.3% 3,561.17 3,622.69 3,613.75 -1.5% 0.2% 6.5% -0.5%
13 Medical House (The) 59.00 59.50 57.00 3.5% 4.4% 3,354.31 3,253.71 3,267.74 2.6% -0.4% 0.9% 4.8%
14 Isotron 440.00 415.00 412.50 6.7% 0.6% 3,235.21 3,288.77 3,233.51 0.1% 1.7% 6.6% -1.1%
15 Nestor Healthcare Group 156.25 145.00 141.75 10.2% 2.3% 3,649.65 3,632.84 3,647.96 0.0% -0.4% 10.2% 2.7%
16 Smith & Nephew 533.50 546.50 535.00 -0.3% 2.1% 3,702.23 3,678.30 3,617.69 2.3% 1.7% -2.6% 0.5%
17 Shiloh 130.00 136.00 132.00 -1.5% 3.0% 3,669.13 3,678.90 3,753.84 -2.3% -2.0% 0.7% 5.0%
18 SSL International 311.00 310.00 313.00 -0.6% -1.0% 3,707.12 3,689.63 3,682.54 0.7% 0.2% -1.3% -1.2%
19 Whatman 246.50 239.00 247.00 -0.2% -3.2% 3,629.03 3,504.54 3,443.81 5.4% 1.8% -5.6% -5.0%
20 Zi Medical 13.75 14.60 15.50 -11.3% -5.8% 3,614.60 3,643.52 3,594.94 0.5% 1.4% -11.8% -7.2%
(Source: uk.finance.yahoo.com)
Annexure III – Movement in net income and net cash flows from operations
S.No. Name Direction of change in net income Direction of change in op. cash flows Abnormal returns over
5-day Same day
1 1st Dental Laboratories + - -14.30% 0.46%
2 Advanced Medical Solutions Group + + 0.49% 5.82%
3 Bespak + + -0.18% 1.43%
4 Biocompatibles International - + -2.66% 3.51%
5 Care U.K. + + 2.81% 4.59%
6 Corin Group + + 0.43% -1.76%
7 DawMed Systems - - 4.77% 4.85%
8 Dechra Pharma + + 0.29% 2.73%
9 Ferraris Group - + 1.28% 11.46%
10 Gyrus Group - + 10.41% 8.89%
11 Huntleigh Technology + + -4.81% -3.43%
12 Medisys - - 6.53% -0.54%
13 Medical House (The) - - 0.86% 4.82%
14 Isotron + + 6.61% -1.10%
15 Nestor Healthcare Group - + 10.18% 2.71%
16 Smith & Nephew - + -2.62% 0.47%
17 Shiloh - - 0.74% 5.03%
18 SSL International - - -1.31% -1.15%
19 Whatman + + -5.58% -5.00%
20 Zi Medical + + -11.84% -7.16%
Annexure IV - Regression analysis between percent change in net income and one day abnormal share price returns
Regression Statistics
Multiple R 0.506
R Square 0.256
Adjusted R Square 0.215
Standard Error 0.040
Observations 20
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 0.011 0.009 1.215 0.240 -0.008 0.031
Net income -0.007 0.003 -2.491 0.023 -0.013 -0.001
Annexure V - Regression analysis between percent change in net cash flows from operations and one day abnormal share price returns
Regression Statistics
Multiple R 0.114
R Square 0.013
Adjusted R Square -0.042
Standard Error 0.046
Observations 20
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 0.018 0.010 1.772 0.093 -0.003 0.040
Cash flow from op. -0.003 0.007 -0.488 0.631 -0.018 0.011
Annexure VI - Regression analysis between percent change in net income and five days abnormal share price returns
Regression Statistics
Multiple R 0.240
R Square 0.057
Adjusted R Square 0.005
Standard Error 0.063
Observations 20
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept -0.003 0.015 -0.234 0.818 -0.034 0.027
Net income -0.004 0.004 -1.048 0.309 -0.013 0.004
Annexure VII - Regression analysis between percent change in net cash flows from operations and five days abnormal share price returns
Regression Statistics
Multiple R 0.010
R Square 9.80E-05
Adjusted R Square -0.055
Standard Error 0.064
Observations 20
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 0.001 0.014 0.072 0.943 -0.029 0.031
Cash flow from op. 0.000 0.010 0.042 0.967 -0.020 0.020
Annexure VIII – Ratio of net cash flows from operations to net income
S.No. Name Ratio of cash flows to net income Abnormal % change
Latest results Previous results 5-day 1 day
1 1st Dental Laboratories -1.07 0.38 -14.3% 0.5%
2 Advanced Medical Solutions Group 1.40 0.82 0.5% 5.8%
3 Bespak 2.00 1.07 -0.2% 1.4%
4 Biocompatibles International -60.71 -0.64 -2.7% 3.5%
5 Care U.K. 2.76 2.68 2.8% 4.6%
6 Corin Group 1.11 1.06 0.4% -1.8%
7 DawMed Systems 0.95 1.24 4.8% 4.9%
8 Dechra Pharma 2.08 1.71 0.3% 2.7%
9 Ferraris Group -0.55 4.89 1.3% 11.5%
10 Gyrus Group 3.87 1.94 10.4% 8.9%
11 Huntleigh Technology 1.82 2.14 -4.8% -3.4%
12 Medisys 0.48 0.14 6.5% -0.5%
13 Medical House (The) 0.15 -0.20 0.9% 4.8%
14 Isotron 2.57 6.13 6.6% -1.1%
15 Nestor Healthcare Group -0.51 2.72 10.2% 2.7%
16 Smith & Nephew 1.81 1.45 -2.6% 0.5%
17 Shiloh 0.70 1.97 0.7% 5.0%
18 SSL International -8.16 1.07 -1.3% -1.2%
19 Whatman -25.94 -4.65 -5.6% -5.0%
20 Zi Medical 0.76 1.02 -11.8% -7.2%
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