Cash flow prediction is more useful than earning prediction!

Cash flow prediction is more useful than earning prediction! Lynn Yan, 50095059 Christina Leung, 50181644 Wayne Yip, 50196995

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 company’s 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 company’s ability to meet its obligations and to pay dividends. • Assessing the company’s 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 enterprise’s 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. What’s 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 borrower’s 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 borrower’s 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 argument’s 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 prediction’s 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 company’s 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 company’s external financing • Ability to meet its obligations and to pay dividends. • Provide advance warning of potential cash shortages

Cash flow prediction is more useful than earning prediction!