Creditors' Use of Operating Cash Flows: An Experimental Study *

Abstract

Financial decision-making research contains a vast array of studies that focus on investors and analysts, though relatively few examine creditors' decision making (Billings and Morton, 2002). Our research narrows that gap by exploring how creditors use operating cash flow and earnings information in ambiguous settings. The Financial Accounting Standards Board (FASB) identifies creditors as primary users of financial statement information in their conceptual framework, and targets their discussion regarding the qualities of financial reporting equally towards investors and creditors (FASB, 1978). The banking industry was highly influential in advocating audited financial statements, and financial reporting has historically emphasized information necessary for lending decisions (Pava and Epstein, 1993). In addition, debt financing far exceeds equity financing for publicly-traded firms, further emphasizing the need to explore creditors' behavior (Billings and Morton, 2002). The current economic and political climate where more emphasis is put on information transparency and financial oversight also motivates the need to understand creditors' use of financial statement information. Changes to existing reporting and oversight requirements need to be predicated with evidence that indicate where current systems are vulnerable. Without research investigating creditor decision-making behavior, it is difficult to identify changes that will improve current reporting systems. Investors and creditors differing goals offer initial clues to differences in their decision-making behavior. Investors are the residual owners and their returns are limited only by the opportunity set and managerial motivations (Jensen and Meckling, 1976). Thus, they place primary emphasis on profitability to signal whether their return expectations will be met. Operating cash flow and solvency are secondary concerns to investors (Ettredge and Fuller, 1991; Hayn, 1995). Creditors have a fixed return and are exposed to agency issues that motivate management to take risks not anticipated at the initial lending decision (Jensen and Meckling, 1976). Creditors then turn their primary focus towards solvency with profitability as a secondary concern. Hence, creditors likely place emphasis on liquidity and cash flow as signals indicating creditworthiness. Operating cash flow helps creditors identify the company's ability to generate cash flow from their ongoing business activities. As such, we would expect creditors to have a clear understanding regarding the relationships between changes in operating cash flow and creditworthiness. In this article we report the results of an experiment that tests whether creditors use operating cash flows as prevailing theory prescribes (e.g., Barth et al., 2001; Barth et al., 1999). Specifically, we examine whether creditors use the relationship between earnings and operating cash flow to signal the degree of transitory and permanent components in earnings. Permanent components are reflective of the long-run normal operations of the company. Transitory events are episodic and may be a function of economic cycles, random events, or temporary conditions (e.g., a union strike). Forecasting future cash flow and profitability requires skilled analysis that can separate events into permanent and transitory categories to assess the impact of past performance on future expectations. When transitory events are unusual and infrequent, accounting principles permit them to be separated on the income statement as extraordinary items. However, many transitory components do not meet the extraordinary criteria and are thus integrated in the operating statements without special note. Hence, the sophisticated financial statement user must recognize how particular financial statement components reflect the transitory and permanent components. Creditors should be attuned to such nuances as they evaluate lending requests. …