Predictive ability of current earnings and cash flows

Abstract

This research investigated the ability of current earnings and cash flows to predict future cash flows and future share prices. The investigation was conducted used financial information of JSE listed companies over a period between 2001 and 2011. The objectives of the research were to establish the predictive ability of current earnings and cash flows on future cash flows and share prices. This study was motivated by the findings of Kim and Kross (2005) where they consolidated the earlier findings by Collins et al. (1997) and Dechow et al. (1998).It was predetermined that the study would add to the body of knowledge in financial statements analysis and the application of earnings and cash flows as the predictive financial variables, Earnings are regarded as an essential measure of company of company‘s performance and cash flows from operations as a measure of the company‘s ability to generate cash flows from their operations. It was noted that investors do study and analyse these financial elements when investment decisions are made (Higgins, 2009; De Fond and Hung, 2003).It was found that earnings did not have the predictive ability on future cash flows but proved to possess high predictive power over future share prices. The results were not in agreement with the previous studied on the same subject. The average of R-square on current earnings ability to predict future cash flows were R2=0.27 and 0.38 in the long run and short run, respectively. The predictive ability on future share prices were R2=0.44 and 0.54 in the long and short run, respectively. Current cash flows on the hand indicated low predictive ability on future share price where the average R2=0.24 and 0.33 in the long and short run respectively. The predictive ability on current cash flows over future cash flows proved to be higher, which was not consistent with the previous researchers. The average R2 were 0.44 and 0.46 in the long and short run. It was noted that these financial elements proved to possess higher predictive abilities in the short run.