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03/22/2010

A Comparison of the Returns Performance for Reported and Revised Measures of Cash Flow


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Cash_Flow_Analytics_webTraditional measures of cash flow are typically based on GAAP-defined calculations of operating cash flow. However, as documented extensively in Financial Warnings (Mulford and Comiskey, 1996), The Financial Numbers Game: Detecting Creative Accounting Practices (Mulford and Comiskey, 2002), and especially, Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance (Mulford and Comiskey, 2005), cash flow measures based on GAAP are easily open to manipulation and, because they exclude the implied cash effects of non-cash transactions, are often misleading. 

An effective means of addressing problems with reported cash flow is to calculate a revised measure of cash flow using the income statement adjusted for changes in relevant balance sheet accounts. For example, reported operating cash flow will exclude the implied cash flow effects of acquisitions and foreign exchange on working capital. Reported capital expenditures will exclude the implied cash flow effects of non-cash capital expenditures. In this note, we compare the returns performance of reported operating cash flow and reported free cash flow with a revised measure of free cash flow determined using the income statement adjusted for changes in relevant balance sheet accounts.

Design

Our sample covers the period from the beginning of 1997 through the end of December 2008. We focus on non-financial firms followed by COMPUSTAT and examine three measures of cash flow: reported operating cash flow, reported free cash flow (reported operating cash flow less reported capital expenditures), and a revised measure of free cash flow calculated by adjusting each income statement account, excluding nonrecurring items, for changes in the relevant balance sheet accounts. We scale each measure by revenue, and consequently, focus on a margin.

For each of these three margins and for each quarter in our sample period, we define a signal that takes the value of one if the margin is greater than the corresponding industry median value (high industry cash flow margin) and zero (low industry cash flow margin) otherwise. This 1,0 signal provides three cash flow-related factors employed in a stock-scoring model: (1) the level of the cash flow margin, (2) its one-year change and (3) its three-year rate of change. In addition to these cash flow factors, four other factors are used in the model, (4) the one-year change in financial leverage (assigned a 1 if below the industry median, 0 otherwise), (5) the three-year rate of change in total asset days (assigned a 1 if below the industry median, 0 otherwise), (6) the one-year rate of change in net margin (assigned a 1 if above the industry median, 0 otherwise), and (7) each firm’s PEG ratio (assigned a 1 if below the industry median, 0 otherwise). Each firm in the sample is assigned to one of five size-related portfolios and one of eight score-related portfolios (for model scores of 0 through 7). Average daily portfolio returns are then calculated, changing firm membership across the portfolios as firm’s size or scores change.

Results

Table 1 presents the simple correlations between the three cash flow metrics. The three cash flow measures are not highly correlated. Revised free cash margin has a correlation coefficient with reported operating cash margin of only 0.36. It’s correlation with reported free cash margin is about 0.48. In untabulated results, revised free cash margin and reported operating cash margin give conflicting buy/sell signals in roughly 30% of the observations. Revised free cash margin and reported free cash margin give conflicting signals in roughly 25% of the observations. In sum, the revised free cash margin signal differs significantly from reported measures of cash flow.

Table 1: Correlations

Panel A: Correlation among different cashflow measures

RevFCMRepOCMRepFCM
RevFCM1.000.360.48
RepOCM1.000.69
RepFCM1.00

  • RevFCM – Revised free cash margin
  • RepOCM – Reported operating cash margin
  • RepFCM – Reported free cash margin

Given the significant differences in the signals created from the different cash flow measures, we next examine which metric is more informative. Table 2 shows average daily return differences using the cash flow signals discussed above over the entire 1997 to 2008 sample period. We follow stocks between successive earnings announcement dates and track differences between the cash flow signals on a daily basis.

As shown below, high revised free cash margin firms outperform high reported operating cash margin firms by a statistically significant 0.009 bps per day. Compounded over one year (where one year is assumed to be 250 trading days), this amounts to outperformance of 2.15% per annum. Similar results are obtained when revised free cash margin is compared to reported free cash margin. The outperformance is a statistically significant 1.00% per year.

Table 2: Return differences to alternative cash flow measures

Avg. Daily Return Difference (in bps)P-valueCompounded over One Year
High RevFCM vs. High RepOCM0.0090.012.15%
High RevFCM vs. High RepFCM0.0040.041.00%
Low RevFCM vs. Low RepOCM-0.0080.01-1.98%
Low RevFCM vs. Low RepFCM-0.0030.25-0.75%
High RevFCM – Low RevFCM0.0270.006.98%
High RepOCM – Low RepOCM0.0100.172.53%
High RepFCM – Low RepFCM0.0200.015.05%
(High – Low RevFCM ) – (High – Low RepOCM)0.0170.014.26%
(High – Low RevFCM ) – (High – Low RepFCM)0.0070.001.77%

  • High (Low) RevFCM – Revised free cash margin is above (below) the industry median.
  • High (Low) RepOCM – Reported operating cash margin is above (below) the industry median.
  • High (Low) RepFCM – Reported free cash margin is above (below) the industry median.

Similar results hold for low revised free cash margin firms. Low revised free cash margin firms outperform low reported operating cash margin firms by 1.98% over one year. Similarly, low revised free cash margin firms outperform low reported free cash margin firms by a statistically significant 0.75% per year.

The signal developed using revised free cash margin outperforms the other measures. High revised free cash margin firms outperform low revised free cash margin firms by approximately 6.98% per annum. Reported operating cash margin is not a reliable signal. High reported operating cash margin firms do not outperform low reported operating cash margin firms. High reported free cash margin firms outperform low reported free cash margin firms by approximately 5.05% per annum. This is significantly less than the value generated by free cash margin.

Furthermore, portfolios that go long the difference between high and low revised free cash margin and short the difference between high and low reported operating cash margin produce a statistically significant gain of 4.26% per year, while the corresponding figure for reported free cash margin is 1.77% per year.

Conclusion

In sum, the results show a signal based on revised free cash margin produces a significantly higher return than corresponding signals produced using either reported operating cash margin or reported free cash margin. Any quantitative model currently using a cash flow signal could potentially benefit from using a revised measure of cash flow that is calculated using the income statement and relevant balance sheet changes.

--Jonathan E. Clarke and Charles W. Mulford 

For more information on revised measures of cash flow and Cash Flow Analytics’ (“CFA”) other proprietary metrics, please go to www.cashflowanalytics.com/register.php and register to learn more about CFA’s quantitative and qualitative investment research and analysis solutions.

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