Financial Statement Analysis and Valuation

Lecture 3
Ignacio García de Olalla
 (Pettersen, Plenborg & Kinserdal Ch.3)
Accrual-based vs. Cash-flow-based performance
measures.
 Accrual-based versus cash-flow-based
performance measures

Period P-1 P0 P1
Transaction      
1   -1000-1000+2600+2600  
  P PCR S PCU  
2 -100-100+200 +200  
P PCR S PCU  
3 -2500-2500 +4800+4800  
P PCR S PCU  
4 -3100 -3100+6000+6000  
P PCR S PCU  
5   -1000-1000+1400 +1400
  P PCR S PCU
6   -3000-3000 +5700+5700
  P PCR S PCU
7   -3900 -3900+5500+5500
  P PCR S PCU

P=Purchase PCR=Payment to creditor S=sales PCU=Payment from customer

 Accrual-based versus cash-flow-based
performance measures
• Accrual-based earnings for P0:
Revenues P0 2600+4800+6000+1400= 14800
CgS P0 1000+2500+3100+1000= 7600
Accrual based earnings P0 7200

• Cash flow for P0:

Cash Inflow 2600+200+4800+6000= 13600
Cash outflow 1000+3100+1000+3000= 8100
Cash Flow P0 5500

• Traditional CF statement:
Accrual-based earnings P0 7200

Begin End
Inventory 5600 6900 -1300
Acc. Receivable 200 1400 -1200
Acc. Payable 3100 3900 800
Cash flow at P0 5500
 Accrual-based versus cash-flow-based
performance measures
• Why these differences?
• Accrual accounting recognises revenues and expenses as they
occur, not as when the actual cash is received or paid.

Revenues are recognised in the period they are sold or the service is performed.
Expenses are recognised in the period they are used in order to produce
revenues.

• In general, we can say that cash flow accounting is more

prudent.
 Accrual-based versus cash-flow-based
performance measures
• Some accrual-based performance measures:
Revenue
-Operating costs excluding depreciations and write-downs
=Operating earnings before depreciation, amortisation and impairment losses (EBITDA)
-Depreciation, amortisation and impairment losses
=Operating earnings (EBIT)
+/- Net financial assets
=Ordinary earnings before tax (EBT) (ordinær resultat før skatt)
+/- Tax on ordinary profit
=ordinary earnings after tax (ordinær resultat)
+/- Extraordinary items, discounted operations and change in accounting policies
=Net Earnings E (resultat)
+/- Transactions recognised directly in equity
=Comprehensive income (utvidet resultat)

• EBIT represents the earnings which are likely to recur.

• Comprehensive income includes everything.
 Accrual-based versus cash-flow-based
performance measures
• Cash-flow performance measures:

Operating income (EBIT)

+/- Adjustment for items with no cash flow effects (depreciation, provision, etc)
+/- change in net working capital
+/- corporate tax
=Cash flow from operating activities
+/- Investments in non-current assets, net
=Cash flow after investments (free cash flow, FCF)
+/- Financing items
=Net cash flow for the period

• Net cash-flow for the period is rarely used by analysts.

 Accrual-based versus cash-flow-based
performance measures

• Measuring earnings capacity:

• We have to be careful about what measures we are comparing.

• For example: EPS (earnings per share) is accrual-based and looks into the short-term
past performance, while SVA (shareholder value added) is cash-flow based and looks
into the long-term future cash flow generation, taking growth and risk into account.
 Accrual-based versus cash-flow-based
performance measures

• Shortcomings of accrual-based and cash-flow based performance concepts:

• Problems related to accrual-based measures:
• Arbitrary cost allocation and accounting estimates
• Alternative accounting policies

• Time value of money is ignored.

• Problems with cash-flow-based performance measures:

• Failure to account for uncompleted transactions (the information content of cash flows is
expected to decrease with the length of a firm’s transactions or operating cycle).

• Cash flows can be manipulated (for example factoring, or deferring the purchase of
inventories)
 Accrual-based versus cash-flow-based
performance measures
• The information content of accrual-based and cash-flow-based performance
measures:

• Dechow (1994), Ali and Pope (1995) and Plenborg (1999) show that accrual-based performance measures
are better at measuring the earnings capacity of a firm:
• Net earnings are able to explain about 11% of the price movements within a year.

• Cash flow from operations about 4%.

• FCF about 0%.

• If we increase the measurement period to 4 years, both accrual and cash based measures improve, but
still accrual overperforms. FCF remains insignificant.
 Accrual-based versus cash-flow-based
performance measures

• While cash flows are less informative than accrual-based performance measures, they still provide
useful information for the analyst:

1. Assessment of earnings quality: There is more subjectivity in accounting earnings than in cash
flows.
• However, over the long run they should be close (in cumulative terms i.e., accumulated
accounted profit vs. cumulative cash flow).

2. Assessment of financial fexibility:

• Does the firm generate sufficient cash to finance its growth?
• What sources of capital a company relies on when it needs funding?

3. Assessment of short- and long-term liquidity risk:

• Cash flow statements are often used in the calculation of financial ratios that assess short- and
long-term liquidity risk.
 Accrual-based versus cash-flow-based
performance measures
• Approximation to cash flows
• In recent years there has been a trend to use EBITDA and EBITA as approximations to cash flow
measures. This is intended to eliminate accounting differences between firms. For example EV/EBITDA
(when using multiples).

• Problems with EBITDA :

1. Difficult to justify that depreciation is not a part of operations.

2. Difficult to compare businesses that grow organically with those that grow by acquiring other
businesses, since the accounting treatment of certain items (such as goodwill) differs.

3. Changes in the accounting of intangible assets. Before: development was expensed as incurred.
Now, as a general rule, it must be capitalised. EBITDA is inflated incomparison!
• To make things worse, some firms fail to capitalize development costs!
 Accrual-based versus cash-flow-based performance
measures

• Approximation to cash flows

• Problems with EBITDA :

4. As cash flow measures EBITDA fails to account for investments in non-current assets and investments in
working capital.

• Be cautious! They are not the same as cash flow measures and can actually very far away from them!