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Review questions

A cash flow based performance measure only recognises a transaction when it has a cash flow impact. An accrual based performance measure typically recognises a transaction at an earlier stage through the use of specific accounting standards – in an attempt to provide more value relevant information to users.

  • Gross profit
  • EBITDA (earnings before interests, taxes, depreciation and amortisation)
  • EBIT (earnings before interests and taxes)
  • EBT (earnings before tax)
  • E (net earnings)
  • Cash flow from operating activities
  • Cash flow from investing activities
  • Cash flow from financing activities
  • Net cash flow for the period

Present value (end)

– Present value (begin)

+ Dividends

– Capital contribution

= Shareholder value added (SVA)

A single-period performance measure only takes into account transactions within one measurement period such as one year. EBIT is an example of a single-period performance measure. A multi-period performance measure takes into account transactions covering several measurement periods. Shareholder value added is an example of a multi-period performance measure.

Criticism of cash flow based performance measures may be summarised as follows:

  • Failure to account for uncompleted transactions
  • Cash flows can be manipulated
  • No matching of cash flow and cash outflow from the same transaction

Criticism of the accrual based performance measures may be summarised into the following points:

  • Accruals problems – i.e. earnings measures can be manipulated (Arbitrary cost allocation and accounting estimates and alternative accounting policies)
  • Time value of money is ignored

Often, the disadvantage of the cash flow based performance measures become the advantage of the accrual based performance measures and vice versa. For instance, accrual based performance measures account for incompleted transactions and match revenue with expenses from the same transaction.

Empirical tests across countries reveal that accrual based performance measures are more value relevant than cash flow based performance measures. For example, accrual based performance measures are able to explain approximately 10% of the annual stock return in comparison to 0%-4% for cash flow based performance measures.

It is important to note cash flow based performance measures has incremental information content beyond accrual based performance measures.

  • Assessment of earnings quality
  • Assessment of financial flexibility
  • Assessment of short- and long term liquidity risk

EBITDA is by some regarded as a useful proxy for cash flows from operating activities as it excludes the impact of non-cash items like depreciations and amortisations. However, using EBITDA as a measure of cash flows is problematic. First, it is difficult to justify that a significant portion of a firm’s costs is excluded from operations. Depreciation is a proxy for the use of resources (e.g. property, plant, and equipment) that is needed in generating earnings. Thus, EBITDA includes the benefits (revenue) from those resources but excludes the related costs. Second, if EBITDA is used as a performance measure it will be difficult to compare businesses which grow organically with businesses which grow through acquisitions. For example, businesses that generate goodwill internally must expense those goodwill outlays due to measurement problems. Firms which acquire other businesses or activities, on the other hand, must capitalise goodwill, while the consumption of goodwill (goodwill impairment losses) is not recognised in EBITDA. Third, EBITDA does not take into account investments in net working capital (i.e. inventory, accounts receivable and operating liabilities) and taxes.