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Investigating causality between cash flow and profitability: an econometrics approach

A. Bezuidenhout (Graduate School of Business, University of Stellenbosch)
C. Mlambo (Graduate School of Business, University of Stellenbosch)
W.D. Hamman (Graduate School of Business, University of Stellenbosch)

Meditari Accountancy Research

ISSN: 1022-2529

Article publication date: 1 April 2008

Abstract

In financial analysis, forecasting often involves regressing one time series variable on another. However, to ensure that the models are correctly specified, one needs to first test for stationarity, co‐integration and causality. In testing for causality, the variables should be stationary. If non‐stationary, one can estimate the model in difference form, unless the variables are co‐integrated. This article determines whether cash flow and earnings variables are stationary, and which variable causes the other, using econometric analysis. In most cases, cash flow variables are found to cause earnings variables. This is so when the models are estimated in levels. However, when estimated in first differences, the causal relationship tends to be reversed such that earnings cause cash flows. Further study is recommended, whereby panel data could be used to improve the power of the tests.

Keywords

Citation

Bezuidenhout, A., Mlambo, C. and Hamman, W.D. (2008), "Investigating causality between cash flow and profitability: an econometrics approach", Meditari Accountancy Research, Vol. 16 No. 1, pp. 27-41. https://doi.org/10.1108/10222529200800002

Publisher

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Emerald Group Publishing Limited

Copyright © 2008, Emerald Group Publishing Limited