Nancy B. King: Quality of Earnings

Fri, 11 Nov 2005 07:20:03 GMT

Quality of Earnings: A Red Flag is raised by Companies that restate their earnings and have high accruals A study by two Wharton Professors----Why Firms Restate Annual Earnings and Why Investors Should Beware. Net Income, Cash Flow, and Accruals (the accrual method of accounting):

The portion of net income that is not accounted for in cash flow is known as accruals; and whenever net income grows faster than cash flow, accruals are the cause. While many elements of accruals are perfectly proper, accruals also leave room for accounting gimmickry or 'earnings management'---fudging numbers to inflate income.

So, that is what they do. Here is how they do it---Four ways companies can manipulate earnings through the use of accruals: (the numbering is mine)

Earnings can be inflated through accruals in many ways. (1) A company might exaggerate its revenues or count money that is expected but not in hand. (2) It might exaggerate accounts receivable, perhaps ignoring the fact that orders for future delivery can be cancelled. (3) A company can pump up sales by offering customers easy credit, but not account for the fact that customers who are not creditworthy may fail to pay. (4) A company might build up inventories toward the end of the year, making production figures look good but saddling itself with excess product that will have to be discounted to be sold, hurting future results.

Okay fellow investors, this means we should check the growth rate of Net Income vs the growth rate of Cash Flow (amount for this year - amount for last year ÷ the amount for last year x 100 = percentage of growth from last year to this year). If Net Income is growing faster than Cash Flow, the question is why. Is it a legitimate reason or not? Is the difference in growth rates for one year or for two or three years?

Mon, 24 Oct 2005 22:56:33 GMT

Checking the Quality of Company Earnings The following sidebar Quantifying Earnings Quality by Cecily J. Fluke with the article, Priced for Perfection by Nathan Vardi in the June 10, 2002, issue of Forbes gives ways to check the quality of company earnings.

We looked at six pairs of numbers, comparing growth in one with growth in the other. In each case earnings quality was associated with a higher growth in the first quantity than in the second. The pairs: cash flow from operations (net of tax savings from stock options) and diluted earnings per share; depreciation/amortization and capital expenditures; cost of sales and ending inventory; sales and receivables; operating income and long-term debt; sales per share and diluted earnings per share.

After coming across this article and reading the above sidebar, I began wondering if the six pairs of numbers were useable. Could I find the specific pieces of data, do the calculation, and use the information in a meaningful way? Below are the results of my efforts. I chose American Eagle Outfitters (AEOS), a stock I had just completed analyzing using my worksheet. I have listed my findings and opinions below if you want to replicate them or want to try it with one of your stocks. Each of these six items require calculating growth rates using 2001 and 2000 data. The growth rate calculation is: (2005 figure minus 2004 figure) (÷ by 2004 figure) (x 100) = percent growth. I used data from Reuters.com (may require free registration). In each case, for quality earnings, the first growth rate of the pair should be greater than the second growth rate. 1. Cash Flow from Operations growth rate versus EPS growth rate----85.7% vs 159.4% respectively. (Unusually high EPS growth rate) a) Cash Flow from Operations----use Total Operating Activity on the Annual Cash Flow Statement b) EPS----use Diluted Excluding Extraordinary Items on the Annual Income Statement 2. Depreciation/Amortization growth rate versus Capital Expenditures growth rate---13.8 % versus 25.5% respectivelty. (Spent more for Capital improvements than was gained through depreciation deductions) a) Depreciation/Amortization/Depletion----use Depreciation/Amortization/Depletion on the Annual Cash Flow Statement b) Capital Expenditures----use Capital Expenditures on the Annual Cash Flow Statement 3. Cost of Sales growth rate versus Ending Inventory growth rate---13.3% versus 14.4% respectively. (OK---very close) a) Cost of Sales---use Cost of Revenue on the Annual Income Statement b) Ending Inventory---use Total Inventory on the Annual Balance Sheet 4. Sales growth rate versus Receivables growth rate---31.1% versus 9.5% respectively. (Good---goods have actually been paid for) a) Sales--use Revenues on Annual Income Statement b) Receivables--use Accounts Receivable (Trade), Net on the Annual Balance Sheet 5. Operating Income growth rate versus Long-Term Debt growth rate---172.1% versus -100% (Good---They paid off long-term debt) a) Operating Income--use Operating Income on the Annual Income Statement b) Long-Term Debt--use Total Long-Term Debt on the Annual Balance Sheet 6. Sales per Share growth rate versus Earnings per Share growth rate---26.3% versus 159.5% respectively. (Unsually high EPS growth rate) a) Sales per Share--calculate it--Use Revenue on Annual Income Statement divided by Diluted Weighted Average Shares on the Annual Income Statement b) Earnings per Share--use Diluted Excluding Extraordinary items on the Annual Income Statement An interesting exercise. I am not sure which of these I will use in addition to my usual calculations---probably numbers 1 and 4.

Mon, 24 Oct 2005 00:31:32 GMT

test entry