On the analysis of firms' cash flows

This paper revisits the whys and hows of cash flows analysis. In a context of equity valuation, we consider three aspects. First, we consider why there is demand for an analysis of cash flows that complements generally accepted accounting principles' (GAAP's) income statement. The issues here pertain to the ambiguity inherent in accruals, primarily due to current and past nonrecurring items, and how one assesses the quality of earnings. Second, we suggest how an analysis of cash flows should be done to assess the extent of biases in accruals. We propose a framework of modified cash accounting (MCA) that satisfies a crucial property: it works just like a regular income statement except that it eschews all accruals. Because an MCA statement depends on consecutive balance sheets (like any standard accounting framework), the core of MCA hinges on what assets and liabilities have been qualified as cash, approximate cash, and the negative thereof. It differs from GAAP's statement of cash flows because it relies on a broader concept of "cash", and MCA has a clear format like an income statement. The paper motivates and shows in some detail how one develops an MCA statement. A final issue deals with how one can assess the quality of a (GAAP) earnings statement by comparing it with an MCA statement. We start from the observation that MCA earnings and GAAP earnings should be the same under the ideal condition when the firm is in a steady state. We then discuss how one can estimate a firm's current-period growth and use this to estimate a normal accrual; this number can then be added to MCA's earnings to obtain a bottom line that compares with GAAP's earnings.