Evidence on the Relationships Between Earnings and Various Measures of Cash Flow.

Abstract ABSTRACT: In recent years, there has been renewed interest in cash flows. This paper describes empirical relationships between signals provided by accrual earnings and various measures of "cash flow" (CF). We Include among definitions of CF both "traditional" measures that Include simple adjustments to earnings data (i.e., net Income plus depreciation and amortization, and working capital from operations) as well as "alternative" measures that incorporate more extensive adjustments (defined in the paper). Evidence is presented on three Issues. First, the correlations among various measures of CF are examined to determine whether the signal provided by a given CF measure differs from the signal provided by others. Second, various measures of CF are correlated with earnings to lend evidence on whether the CF and earnings signals are similar. Third, we provide evidence on the ability of earnings and cash flow measures to forecast one period and two period ahead cash flows and, in so doing, we examine the FASB's assertions that earnings are superior to CF in predicting future CF. Results can be summarized as follows. First, the observed correlations between traditional cash flow measures and alternative CF measures that Incorporate more extensive adjustments are low. Second, the correlations between alternative measures of CF and earnings are low while the correlations between traditional measures of CF and earnings are high. These first two results are consistent with earnings and alternative measures of CF that Incorporate more extensive adjustments conveying different signals. Finally, for four out of five cash flow variables, the results are consistent with the hypothesis that random walk models predict CF as well as (and often better than) models based on other flow variables. An...