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How to assess earnings quality?

Sep 12, 2011

Stock prices are slaves of earnings growth. Over a longer period of time, growth in earnings is bound to reflect in the stock prices. Thus, there is strong incentive for the management to report superior earnings growth. And sometimes this incentive takes the form of greed as management compensation is aligned to the performance of the company. The pressure to outperform peers and meet expectations related to the growth guidance brings earnings manipulation into picture. Hence, assessing the earnings quality of any company assumes a great deal of importance. And for that one needs to understand that earnings typically comprise of two components: - one is the cash component and second is the accrual component. Higher the accrual component in the earnings basket, lower the earnings quality.

Let us explain it with the help of a simple example. Say you are an owner of ABC Corporation which is into the sales of branded merchandise. In the recent financial year, your company registered sales of Rs 500 m and you have received cash to the tune of Rs 200 m. Thus, while you are yet to receive the cash on balance sales, the profit attributable to that is already reflected in the profit & loss account giving rise to the accrual component. While it is understood that the accrual component arises due to accounting estimations, a higher proportion of accruals does indicate red flags. It signals aggressive accounting by the management, a sign of earnings manipulation.

Accrual component arises when there is timing mis-match between the receipt of cash flow and revenues reported that generate the actual cash flow. This typically happens with the construction companies where revenues are booked on percentage of completion method. Although these companies report double digit revenue growth they hardly generate any cash flow signifying that the accrual component in earnings is huge. Hence, the earnings quality of the construction companies is inevitably questioned by the markets.

Apart from aggressive revenue recognition techniques, management also uses various other accounting gimmicks to inflate earnings. Some of them include:-

  • Changing the depreciation method from accelerated to straight line basis
  • Capitalizing expenses that should be expensed
  • Delaying goodwill impairment
  • Changing the inventory cost flow assumptions (FIFO & LIFO) based on the inflationary expectations
  • Increasing the interest rate assumption to calculate the current service cost component of gratuity expenses.
As the reported financials can be window dressed through various accounting practices, one needs to be circumspect in assigning a relatively higher importance to the historical earnings growth. One important ratio that can be really helpful in assessing the earnings quality of the company is:-

Operating Cash Flow/ Net Income

Operating cash flow refers to the amount of cash generated by the company through conducting its day to day operations.

A ratio of greater than or equal to one signifies high quality earnings. As cash flow can't be manipulated, this ratio gives us an important signal about the accrual component in earnings. High earnings that do not match or exceed the operating cash flow are considered to be of poor quality.

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2 Responses to "How to assess earnings quality?"

P.s.edminton[London]

Sep 14, 2011

A strategically diversified geographical presence (sales in 150 countries, de-risked manufacturing in 3 countries) and an international Intellectual Property portfolio (168 patents) puts Opto Circuits in a unique position to leverage the huge USD 22Bn. addressable market that it has set out to target value of Rs 289/- before 19/10/2011,buy must have this script in your portfolio before you miss it,today value of Rs 143/- very attractive,you may not get opportunity to buy.

Like (1)

lalji patel

Sep 12, 2011

Your approach to the above ratio for a good quality consideration seems O K

Like (1)
  
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