The relation between earnings and cash flows

TLDR

The study develops a model linking earnings, cash flows, and accruals based on a random‑walk sales process and limited accrual types. The model predicts serial and cross‑correlations of earnings, cash flows, and accruals and is tested on 1,337 firms from 1963 to 1992. Earnings outperform current cash flows in forecasting future operating cash flows, with the advantage depending on the operating cash cycle, and the model’s predictions align with the data.

Abstract

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firm's series. The implications and predictions are tested on a 1337 firm sample over 1963–1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.