Can Current Earnings Predict Future Cash Flows? A Literature Survey

Investors consider cash flows to be more value relevant than profitability disclosures. This value relevance emerges from low discretionary control of managers on cash flows compared to net income. The accrual accounting is based on recognizing revenues and expenses as they occur and not when the cash transaction takes place. This will result in a variance of net income from cash flows. However, given the nature of accounting system, in general it is assumed that earnings and cash flows are co integrated. As a result, an exhaustive literature exists that attempts to explore the capacity of current earnings in predicting future cash flows of a firm. The findings on the subject are mixed with some studies validating the hypothesis that earnings can be a good predictor of future cash flows, while others refute it questioning the value relevance of earnings. In this literature survey, we present and discuss some notable findings on this important financial issue