Disappearing investment‐cash flow sensitivities: Earnings have not become a worse proxy for cash flow

• Author: Niclas Andrén,Håkan Jankensgård
• Date: 01 May 2020
• DOI: http://doi.org/10.1111/jbfa.12427
• Published date: 01 May 2020

DOI: 10.1111/jbfa.12427

Disappearing investment-cash flow sensitivities:

Earnings have not become a worse proxy for cash

flow

Niclas Andrén Håkan Jankensgård

Department of Business Administration, Lund

University, P.O. Box7080, 220 07 Lund, Sweden

Correspondence

NiclasAndrén, Department of Business Admin-

istration,Lund University, P.O.Box7080, 220 07

Lund,Sweden.

Email:niclas.andren@fek.lu.se

Abstract

According to a recent conjecture in the literature, earnings have

become a poorer proxy for cash flow from operations overtime. We

find that since 1988, when cash flow statements started to be consis-

tently reported in Compustat, the cash effectiveness of earnings has

actually increased for a large sample of US manufacturing firms. This

occurs despite the introduction of fair value accounting and increas-

ing accounting accruals during the last three decades. Also contrary

to the conjecture, using more comprehensive measures of cash flow

does not restore the investment-cash flow sensitivity,which contin-

ues to be around 0.05 in more recent periods.

KEYWORDS

accruals, cash effectiveness, cash flow, earnings, financial con-

straints, investment-cashflow sensitivity, investment

JEL CLASSIFICATION

G30, G32, M41

1INTRODUCTION

According to a recent conjecture in the literature, earnings havebecome a poorer proxy for cash flow from operations

over time (Lewellen & Lewellen,2016). This is not merely a matter of idle interest. Earnings are a standard measure of

operating cash flow in the corporate finance literature. They are generally considered ‘the bottom line’ performance

measure in the financial community, and the release of quarterly earnings numbers continues to generate a massive

interest among analysts and the business press. As pointed out by Givoly and Hain (2000), a change in the structural

relationship between earnings and cash flow holds important implications for financial analysis, in particular for com-

parisons over time (also see Bilinski, 2014).

Moreover, Lewellenand Lewellen (2016) report important implications of the declining correlation between cash

flow and earnings for a recent puzzle in empirical finance research: the disappearing sensitivity of corporate invest-

ment to cash flow. This strand of research was initiated by Fazzari, Hubbard, and Petersen (1988), who argued that

the empirically observed sensitivity of investment to cash flow (around 0.2 to 0.3) implied the existence of financial

constraints because the subsample of firms deemed a priori more constrained had higher sensitivities. Subsequent

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research has debated whether investment-cash flow sensitivities are actually valid measures of financing constraints.

In an important recent contribution to this literature, Chen and Chen (2012) show that investment-cash flow sensi-

tivities drop to very low levels (around 0.03) in the late 1990s and thereafter,and argue that they cannot reasonably

be good measures of financial constraints since even during the 2007–2009 crisis theydid not return to former levels

eventhough firms were demonstrably constrained in this period. Disappearing investment-cash flow sensitivities have

also been reported in A˘

gca and Mozumdar (2008), Brown and Petersen (2009), Larkin, Ng, and Zhu (2018), Moshirian,

Nanda, Vadilyev,and Zhang (2017) and Allayannis and Mozumdar (2004), among others.

In contrast to these recent studies, Lewellen and Lewellen (2016) report sensitivities more in line with the early

studies in the literature. According to their results, using an improved measure of operating cash flow restores the

investment-cashflow sensitivity to much higher levels. The authors suggest that the correlation between the earnings-

based cash flow measure used by Chen and Chen (2012) and actual operating cash flows declines over time, and that

theincreasingly weak ability of earnings to approximate operating cash flow is an important clue to resolving the puzzle

of declining investment-cash flow sensitivities.

In this article, we examinein detail the two conjectures put forward by Lewellen and Lewellen (2016). First, that the

correlation between earnings and operating cash flows has decreased overtime, and, second, that using more compre-

hensive cash flow measures brings the investment-cash flow sensitivity back to levels observedin early studies in the

financing constraints literature.We create a sample of US manufacturing firms similar to that of Chen and Chen (2012)

between 1988 and 2014, the years in which cash flow from operations is systematically reported in Compustat as an

item in the statement of cash flows. We thereafter investigate the cash effectiveness of earnings using regressions in

which cash flow from operations is the dependent variable. Casheffectiveness is here defined as the sensitivity of cash

flow from operations to a US$ 1 increase in earnings. If it is true that earnings have become a poorer proxyfor operat-

ing cash flow,the cash effectiveness of earnings should decline over time. In the second part of the article, we carry out

regressions similar to those in Chen and Chen (2012) to see if using more comprehensive measures of operating cash

flow influences the disappearance of the investment-cashflow sensitivity.

Contraryto Lewellen and Lewellen’s conjecture, we find that the cash effectiveness of earnings has in fact increased.

The cash effectiveness is trending upwards for the whole sample period. In the first year (1988) the coefficient is 0.59,

whereas in the last five years (2010–2014) it is 0.88, representing an increase of 52%. This suggests that, in recent

times, cash flow from operations on average responds by a change of 88 cents for every US$ 1 change in earnings.

The upward trend in cash effectiveness is observed regardless of whether earnings are the sole independent variable,

or whether additional controls are included. The different conclusions we make in this regard compared to those in

Lewellen and Lewellen (2016) can be attributed to the fact that they report a very high correlation between earnings

and cash flow from operations mainly prior to 1988, when cash flow from operations is not reported but has to be

approximated. During the last three decades,b ased on actualreported cash flow statements, the cash effectiveness of

earnings has actually gone up.

The increased cash effectiveness of earnings over the last three decades is puzzling given the large observable

increase in accounting accruals over this period. Accruals represent adjustments made to cash flows to generate

a profit measure largely unaffected by the timing of receipts and payments of cash (Ball, Gerakos, Linnainmaa, &

Nikolaev,2016). We measure accruals as the difference between reported earnings and cash flow from operations.1

Consistent with Givoly and Hain (2000) we document that accruals increase over time, especially after 2002. Wealso

find that accruals have become much more cyclical in the 2000s. These trends are related to the advent of fair value

accounting, that is, the principle that assets and liabilities are to be carried on the books at their fair estimated market

value (as opposed to their historical cost less accumulated depreciation).

Wefind that a large part of the explanation behind the increase in cash effectiveness over time appears to be related

to more efficient working capital management. For example, consistent with the findings in Bates, Kahle, and Stulz

1Totalaccruals consist of changes in working capital (‘operatingaccruals’) plus non-operating accruals. Non-operating accruals include items like asset impair-

ments,loss provisions, and unrealized gains and losses. A more detailed discussion is found in Section 3.