Working capital management's effect on accrual based prediction of future cash flows: Evidence from North America

Abstract Cash flows are of paramount importance for companies as future cash flows are widely used in company valuation. The role of accruals in predicting future cash flows is one of the central themes in accounting research, but the results are not unambiguous. Accrual quality is closely linked to the fundamental roles of accruals and whether accruals are able to fulfil their role and adjust the recognition of the cash flows to better reflect firm performance. Firm characteristics, such as the length of operating cycle is considered to be factor that has an impact on the accrual quality. This study examines the effect of working capital management on the prediction of one-period ahead cash flows in publicly listed U.S. companies during 1988-2016. The sample consists of financial data from annual financial statements, which were retrieved from the WRDS database and the total sample covers 47,589 firm-observations. The empirical part of this thesis is conducted by OLS regression analysis. The model used in this thesis is developed by Barth et al. (2001) and it predicts one-period ahead cash flow with current period cash flow and six accrual components. In order to examine the impact of working capital management, the sample is divided into five quintiles based on the length of operating cycles and cash conversion cycles. The analysis is conducted by incorporating the operating cycle and cash conversion cycle quintiles into the initial model as well as running the model for each quintile separately. The empirical results suggest that working capital management has a minor positive impact on the overall explanatory power of the model. However, the differences between the groups are not significant and thus, it cannot be concluded that working capital management would impact the prediction of one-period ahead cash flows. Overall, the results suggest that the main role of accruals in adjusting the recognition of cash flows is not dependent on working capital management