The Analysis of Cash Flows .docVIP

On the Analysis of Firms’ Cash Flows James A. Ohlson and Jagadison K. Aier School of Accountancy W. P. Carey School of Business Arizona State University September 2006 Preliminary draft; not to be quoted On the Analysis of Firms’ Cash Flows Abstract ?This paper revisits the whys and hows of cash flows analysis in an equity valuation context. We argue that the high incidence of non-recurring items and, more generally, the ambiguity inherent in accruals force analysts to pay attention to cash flows. However, GAAP’s statement of cash flows embeds several drawbacks. In particular, it lacks a clear “bottom-line” directly comparable to net income per GAAP. We therefore propose a model of Modified Cash Accounting (MCA) which presents an income statement without accruals. This approach differs from GAAP’s in major regards, including the concept of cash and how one distinguishes operating from financial activities. The paper discusses how one motivates, prepares, interprets and uses such a statement to evaluate a firm’s quality of earnings and estimate its core (operating) earnings. The paper thus provides a practical financial statement analysis tool. On the Analysis of Firms’ Cash Flows I. Introduction and Summary A major reason equity analysts evaluate firms’ cash flows stems from analysts perceptions that GAAP’s income statement builds in intrinsic problems. At least two issues concern analysts: The material incidence of non-recurring items (such as restructuring charges) and a general suspicion that accruals reflects “arcane” accounting principles, or even earnings management, no less than economic realities. These characteristics of GAAP cause ambiguities when analysts try to identify a core earnings starting point for purposes of forecasting subsequent periods EPS. They also give rise to issues falling under the heading of “quality of earnings”. There should be no surprise that analysts’ thus turn thei