Estimated Operating Cash Flow, Reported Cash Flow From Operating Activities, and Financial Distress

Terry J. Ward, Benjamin P. Foster and Jon Woodroof
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Terry J. Ward: Middle Tennessee State University, USA
Benjamin P. Foster: University of Louisville, USA
Jon Woodroof: The University of Tennessee, USA

Chapter 5 in Advances in Quantitative Analysis of Finance and Accounting, 2006, pp 97-120 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractBahnson, Miller, and Budge (1996) and Krishnan and Largay (2000) discovered differences between net operating cash flow (OCF) as estimated by prior studies and cash flow from operating activities (CFFO) as reported on the cash flow statement. Our study examines whether these differences could impact the results from financial distress models and explains why prior financial distress research generally found that OCF provided little useful incremental information in explaining financial distress. In our study, OCF does not add significant explanatory power to distress models. In contrast, the operating cash flow variable taken directly from the cash flow statement, CFFO, adds significant explanatory power beyond accrual accounting variables and even beyond OCF. We then conduct analyses to help explain these results. Similar to Bahnson et al. and Krishnan and Largay, we find significant differences between OCF and CFFO. We also find that the differences are significantly different between the distressed and nondistressed groups of firms. Although the differences between CFFO and OCF are significant for both distressed and nondistressed groups, OCF tends to be overstated in greater magnitudes for the distressed firms than for the nondistressed firms. However, OCF is as likely to be overstated as understated for the nondistressed firms. Previous financial distress research studies estimated net operating cash flow variables similar to OCF. Our findings may explain why these studies generally concluded that operating cash flow did not contain incremental explanatory content above accrual information.

Keywords: Earnings Management; Management Compensation; Option Theory and Application; Debt Management and Interest Rate Theory; Portfolio Diversification; Earnings Surprise (search for similar items in EconPapers)
Date: 2006
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