Cash flow prediction is more useful than earning prediction! Lynn Yan, Christina Leung, Wayne Yip,

What is earning? Earning is an increase in capital resulting from the profitable operation of the business. It does not consist of any cash or any other specific assets. Rather, it is a computation of the overall effects of many business transactions on capital.

What is cash flow? Cash flow is cash receipt or cash payment that affect only the cash & cash equivalent balance.

Classification of cash flows Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities

Earning Cash flow In an accrual accounting system, there are often timing differences between cash flows and the recognition of expenses or revenue, e.g. a company can receive cash before earning any revenue (matching principle). There are many non-cash items such as depreciation, inventory write-off that only affect earning.

How to predict earning? Sales forecast future demand ? Production schedule Manufacturing cost budget COGS budget & ending inventory budgets Operating expense budget… It seems that earning prediction may differ a lot since it is determined by so many factors. How can we trust such ambiguous prediction??

How to predict future cash flow? The statement of cash flows assists in assessing the companys ability to generate positive cash flows in future periods. Many future cash events are impounded today in things other than cash. e.g. a company has many $ of receivables from its customers as a result of credit sales that have not yet been collected in cash. These receivables represent expected future cash flow.

Cash flow prediction is useful in Assessing the companys ability to meet its obligations and to pay dividends. Assessing the companys need for external financing. Providing advance warning of potential cash shortages…

Critical importance of cash flows from operating activities(1) In the long run, a business must generate positive net cash flows from its operating activities if it is to survive. A business with negative CF from operations will not be able to raise cash from other sources indefinitely.

Critical importance of cash flows from operating activities(2) The ability of a business to raise cash through financing activities is highly dependent on its ability to generate cash from its normal business operations. Creditors and stockholders are reluctant to invest in a company that does not generate cash from operating activities to ensure prompt payment of maturing liabilities, interest, and dividends. Neither can a company expect to survive indefinitely on cash provided by investing activities.

Requirement from lenders: As a condition for granting a loan, banks often require the borrower to maintain a compensating balance ( minimum average balance) on deposit in a non-interest-bearing checking account, This agreement does not actually prevent the borrower from using the cash, but it does mean the company must quickly replenish this bank account.

Bank Runs: Bank must have enough cash to pay their debtor, most of them are us, the one who deposit in banks. If not enough cash, bank runs may occur. Like the bank runs in the 60s and 80s, the consequences are very serious.

Cash flow prediction is important: Cash flows and available cash tell the company about its ability to pay debts when they fall due. Ignoring cash management may bring a profitable company face the danger of bankruptcy.

Cash is income generating unit It is important that a business should be profitable, but it is also important that the business is able to generate enough cash to ensure its success. Without cash a business will eventually fail, even though it may continue to report profits. Survival of a business depends not so much on profits as on its ability to pay its debts when they fall due.

Cash is income generating unit Cash continuously flows into and out of an active business to generate profit It is the starting and ending process of an enterprises operating cycle. In companies with products to sell, the operating cycle starts when cash is used to acquire inventory and ends when the collection process returns cash from sale of inventory. Cash might be invested in the firms Dividend Wages(Cash) Employees efficiency & effectiveness of employees profit

Cash is income generating unit Bank is one of the business that concern much more about the cash flow WHY?????? Income: Funds on deposit at the bank, Interest from loan Expenses: Interest on deposit in terms of cash; Loan Cash flow is very important for the bank to survive

Cash Flow is more objective Earning prediction have many estimation. Examples – Provision for doubtful debt – Depreciation – Value of intangible assets

Cash Flow is more objective The estimates will affect the objectivity. Cash Flow prediction is more realistic in a sense that it indicate every dollar REALLY earned. Hence Cash Flow prediction is a better prediction.

The PCCW example PCCW is an good illustration for the weaknesses of earning prediction. A year ago, the stock price of PCCW fell dramatically. Whats the cause?

The PCCW example For web based stocks, their profit usually based on some intangible assets. Hard to account for the value of intangible assets. – Hit rate = Profit? – Future earnings = Profit? – Conceptual ideas = Profit?

The PCCW example Those estimations and assumptions are very subjective. Sometimes those information could be misleading, and investors will make the wrong decision.

Cash flow is central to the relationship between banks & borrowers Reasons for good cash flow projections being important to both the bank and the borrower For the borrower: They make it clear whether a loan will help the business to grow and proper Cash flow projections show when the loan is needed For the bank: Whether the borrower will repay the loan or not

Cash flow is central to the relationship between banks & borrowers Banks are primarily concerned with the borrowers cash flow projections and the basis on which they were made When considering a lending proposal………. What does a bank want to hear? What are the criteria banks use in assessing loan proposals?

Cash flow is central to the relationship between banks & borrowers There are a number of traditional approaches to credit analysis: Cash ~ can the borrower repay? Character ~ will the borrower repay? Collateral ~ what will the bank do if the borrower does not repay?

Cash flow is central to the relationship between banks & borrowers The ability of the borrower to repay the loan from cash flow is the most important consideration Bank look to a borrowers future ability to generate operating cash flow as the principal source of repayments In considering a loan proposal, the bank will look very closely at the cash flow projections put forward by the business. Sound cash flow projection includes: Identify cash shortfalls and surpluses; Validate the business plan; Highlight any potential cash problems

Cash flow is central to the relationship between banks & borrowers Most banks found that: The success of a business is closely correlated with its cash flow A profitable business forecast and plan cash effectively Winners have sound cash flow projections: losers do not

Cash flow is central to the relationship between banks & borrowers Cash flow is the most important and primary consideration for lending money to the borrower!!!!!!!!!

Counter arguments critical assumption & standpoint Earning is the best predictor of long-term cash flow. Cash flow concerns about short-term prospect, whereas earning concerns about long-term prospect. Thus earning prediction is more important.

Our defense: There are more uncertainties in long term. Thus the applicability of earning prediction to remote future cash flow is in doubt. How can a company develop in long term if it can not survive even in short term?

Summary Earning prediction is more ambiguous than cash flow prediction. Cash flow predictions usefulness, especially the critical importance of cash flow from operation activities. Efficient cash ensure external financing, and ignorance of cash management may bring a company bankruptcy.

Summary Short term prospect can be more certainly predicted by cash flow than long term prospect by earning. A bird in hand is worth two in the bush. Short term survival (cash flow prediction) is the basis of long term development (earning prediction).

Summary Estimations are subjective, sometime could mislead readers. The companys cash flows in its operating, financing, or investing activities are significant sources of income.

Summary For the banks, the ability of the borrower to repay is the main concern when examining an application for a business loan. Cash flow prediction is useful in – Assessing the companys external financing – Ability to meet its obligations and to pay dividends. – Provide advance warning of potential cash shortages