Earnings versus Cash Flow Returns

Are returns based upon cash flows more reliable measures of investment returns than those based on accounting earnings? Not necessarily, because they make assumptions about cash flows and investment that may not be sustainable. The cash flow return on investment (CROCI) measure treats the operating cash flow as a perpetuity on existing capital invested, an unreasonable assumption since there will be nothing left to depreciate sooner or later. The CFROI measure makes more reasonable assumptions about asset life, but require estimates of asset life that may be difficult to provide for companies with multiple asset classes with different lives.

Table 3 provides a direct comparison of the accounting and cash flow measures of returns, the implicit assumptions that they make and the correct comparison metrics. The debate on which of these measures is the right one takes our focus away from the question of what returns will be on future investments. None of these measures, even if correct, can provide an answer to that question and all of them may contain information that can be used for that forecast.

Measurement Issues and Fixes

The accounting and cash flow measures of returns described in the last section are predicated on the assumption that accounting earnings and capital invested are reasonable estimates of the "true" earnings and capital invested. In this section, we consider the potential problems with this assumption and the adjustments that we need to make as a consequence.

Accounting Misclassification of Expenses

The accounting categorization of expenses into operating, capital and financial expenses lies at the basis of accrual accounting earnings. In theory, the operating expenses refer to expenses designed to generate a benefit only in the current period (labor and raw materials, for instance), the capital expenses relate to expenses that provide benefits over multiple periods (buildings, manufacturing equipment) and financial expenses capture expenditures related to the use of debt (interest expenses are the most common example). While accounting rules stay consistent, for the most part, to this categorization for the most part with manufacturing firms, they fall short with service and technology firms. In this section, we consider two common areas of misclassification - capital expenditures that are treated as operating expenditures and financial expenditures that are includes with operating expenses - and how best to correct for them.

I. Misclassified Capital Expenditures

Consider a technology or a pharmaceutical company with significant growth potential. To convert this growth potential into value, these firms have to invest, but their investment is usually not in land, buildings or equipment but in research and development. Under the rationale that the products of research are too uncertain and difficult to quantify, accounting standards have generally required that R&D spending be expensed in the period in which they occur. This has several consequences, but one of the most profound is that the value of the assets created by research does not show up on the balance sheet as part of the total assets (or capital) of the firm. This, in turn, creates ripple effects for the measurement of capital and profitability ratios for the firm. We will consider how to capitalize R&D expenses in the first part of the section and extend the argument to other capital expenses in the second part of the section.

 

See Technical Indicators