Principally, liquidity is an important variable for the continuing life of a company. This can be seen from the liquidity concept, which is, in general sense, refers to the ability of a company to pay its short term debts as they become due. The corporate liquidity is used by creditor as a parameter for making a decision to give a loan to a company, because they can reasonably expected to be repaid in much the same pattern as the borrowing company has been paying its creditors in the recent past. Creditors indeed look for a high liquidity as their protection. Inattention to the liquidity management process may cause severe difficulties and losses due to adverse short-run developments even for the firm with favorable long-run prospects. Incorrect evaluation of the liquidity implications of a firm, may, in turn, subject creditors and investors to an unanticipated risk of default.

Corporate liquidity has two distinctly different dimensions. That is static and dynamic view of liquidity. Static view such as the current ratio and quick ratio are designed to measure an ability to meet obligations through the liquidation of assets. This static view of liquidity is based only balance sheet data for a given point of time. Hager (1976), Kamath (1989), Richards and Laughlin (1980) and Emery (1984) suggest that a dynamic view is needed to capture ongoing liquidity from the firm’s operations. This dynamic view employs the ‘cash conversion cycle’ to measure corporate liquidity. Usually, a company acquires inventory on credit, which results in accounts payable. The company will then sell the inventory on credit, which results in account receivable. Cash is therefore not involved until the company pays the account payable and collect account receivable. So, the cash conversion cycle measures the time between outlay of cash and the cash recovery. This cycle is extremely important for companies. This measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the greater the corporate liquidity. In this study, we use the cash conversion cycle as the measurement of liquidity. The cash conversion cycle is measured by the inventory period plus the account receivable period minus the accounts payable period. If we looking at from the formula, we can see that the entire component used in the formula is based only in the balance sheet data. So, the validity of the liquidity value is depending on the information provided on the balance sheet data.

One of the characteristics of Financial Statement in order to make it useful for the user is the presence of the relevant characteristics in the information provided in the Financial Statement. According to SAK (2002), the relevant information is information that influences the user in making an economic decision by helping them in evaluating the past and present condition, and to predict the future, or correcting the evaluation report in the past. Based on the relevant information, the ability of the accounting information to predict the condition or certain financial variables in the future then become an important implication for the economic decision maker.

The accounting variables that still become an interesting topic to be examined until now is the earnings and cash flows; especially about their ability in predicting these variables itself and another accounting variables. Barth et al (2001) analyze the ability of earnings and cash flow in predicting future earnings and cash flow. Lancester and Stevens (1998) analyze the use of earnings and cash flow to measure liquidity in empirical studies of corporate performance.

Considering from the measurement principal of the recognition, there is a significant difference between earnings and cash flow. An earnings measurement is based on the accrual accounting rules. Based on the rules, the transactions and other events are being recognized when the transaction or other events occur (not at the time cash is being received or paid) and recorded on the accounting statement and reported on the financial statement at the period (SAK, 2002). The financial statement that has been arranged based on the accrual accounting rules will give some information to user, not only about the past transaction that involved the cash receipt and expenditure, but also the obligation of cash payment in the future. Based on the description above, earnings that reported on the financial statement will determine the liquidity or he ability of a company to pay its short term debt as they become due, if not all of the earnings is divided to the shareholders as a dividend.

Cash flow are not based on the accrual accounting rules, but recognized and recorded when the cash is being received or paid. . in SFAC No. 5, the FASB makes the following claims about a statement of cash flow: it provides useful information about an entity’s activities in generating cash through operations to repay debt, distribute dividends, or reinvest to maintain or expand operating capacity; about its financing activities, both debt and equity; and about its investing or spending of cash. Important uses of information about an entity’s current cash receipts and payments include helping to assess factors such as the entity’s liquidity, financial flexibility, profitability, and risk. In its bearing with the corporate liquidity, because of its reporting principle, hence, cash flow is more relevant compared to earning; because, from the cash flow statement, the real cash have been hold by a company.   So, the calculation of corporate liquidity becomes more accurate. Based on the empirical evidence, the theoretical conclusion of corporate liquidity becomes more accurate. According to FASB, the cash flow data as an important supplement to the accrual-based income (earning) statement. Cash Flow statement has been advocated as a way of dealing with the arbitrariness of income measurement, because cash flow information is free from many of the drawback of accrual concept. Based on the empirical evidence, the conclusion is not supported by some consistent evidence. Lancester and Stevens (1998) analyze that the cash flow can not predict the corporate liquidity measured by the current ratio.

The purpose of this study is to replicate the Lancester and Stevens (1998). The reason is: (1) the study considering the ability of earnings and cash flow in predicting corporate liquidity is rarely performed. (2) an important extension in our study is the use of a dynamic measure of liquidity rather than static liquidity (3) Theoretically, the result of research conducted by Lancester and Stevens (1998) is still required to be conducted at the different time and location, to know whether cash flow is more relevant compared to earnings.

Based on the descriptions and reasons explained above, the writer proposes the thesis entitled: “THE ABILITY OF EARNINGS AND CASH FLOW IN PREDICTING THE CORPORATE LIQUDITY”

 

Based on the background described above, the problems propose in this study are:

1. Do earnings has the ability in explaining the corporate liquidity?

2. Do cash flow has the ability in explaining corporate liquidity?