Sep 12, 2011|
How to assess earnings quality?
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:-
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:-
- 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.
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.
More Views on News
Jun 10, 2017
Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.
Aug 21, 2017
Most Indians who cannot find jobs, look at becoming self-employed.
Aug 21, 2017
PersonalFN explains the chief factor pushing gold prices up of late.
Aug 21, 2017
One of the hallmarks of successful investing is to look out for companies that have a unique and enduring moat.
Aug 19, 2017
Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.
More Views on News
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 8, 2017
'Yes, it looks like a bubble. And, yes, it's like buying a lottery ticket. But there's something happening that has never happened before. It's an evolutionary leap in money itself.'
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 10, 2017
Bitcoin hits an all-time high, is there more upside left?
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. LEGAL DISCLAIMER:
Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here
. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: email@example.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407