Earnings Quality

Before investing, you should determine if financial reports and earnings are worth analyzing by testing their soundness and quality.

This looks like a no-brainer but how many investors do really take the time to do that.

Quality of financial report

The quality of financial reports is the first to consider. It involves how a company recognizes income and expense, how it classifies items in its financial statements, and how it measures certain items.

The CFA recommends the following procedure when analyzing the quality of a company’s financial report:

  • understanding the company’s business and industry;

  • compare the financial statement in the current period and the previous period to see any big differences in items;

  • assess company’s accounting policies (usually described in its financial notes) and check for unusual revenue/expense items in comparison with other companies in the industry;

  • check financial ratios (activity, profitability, liquidity, solvability);

  • check consistency between some income statement items and cash-flow statement items (especially consistency between Net Income and Cash flow from operations).

Quality of earnings

Two important criteria here: sustainability of earnings and return of capital in excess of cost of capital.

Recurrence of earnings is assessed by looking at the ability of a company to generate recurring earnings and not relying on non-recurring items, such as asset disposals and take advantage from one-off items (litigation, restructuring…) to improve future earnings that would look unsustainable afterwards.

Behind the recurrence of earnings is the idea of persistence, which leads to decompose earnings into 2 components: cash component and accrual component, which arises from the timing of cash movements related to balance sheet items such as account receivables, inventory or payables.

Accruals themselves arise from the « business as usual », normal course of activity (« non-discretionary ») and accruals related to transactions or accounting choices that are not normal, i.e. « discretionary ».

Comparing the amount of accruals among companies in the same sector might be a way to determine if one company specifically uses « discretionary » accruals and potentially issues low quality earnings.

Another used indicator of poor earnings quality is a company that reports net income figure inconsistent with operating cash flows.

Key items to consider: Revenue

  • What are the revenue recognition policies? (shipping terms, transfer of property terms, rebates, rights of return given to customers);

  • Check metrics such as DSO, how they evolve and compare within an industry;

  • Check for cash contribution to earnings vs accruals, especially the evolution of account receivables vs revenues;

  • Compare financial metrics with operational KPIs and non-financial metrics when available;

Key items to consider: Expense

  • Expense vs capitalization, obsolescence rules for inventory, what reserves/allowances are used;

  • Depreciation policy;

  • Classification of balance sheet (B/S) items;

  • Confront the evolution of profitability ratios with changes in B/S items (profit margins vs non-current assets for instance);

  • Look at trends in turnover ratios for assets;

  • Compare depreciation expense with the relevant asset base for the company and its competitors;

  • What’s the investment/capex policy of the company (capex/gross PPE)? How does it evolve over time?

Cash flow quality

For investors who want to assess the intrinsic value of a company, understanding how a company generates cash-flows, and how it converts earnings (operating income) into cash and if this cash is sustainable in the long run is paramount.

Per CFA’s curriculum, good quality cash flows have the following characteristics:

« Positive operating cash flow (OCF)

OCF derived from sustainable resources

OCF adequate to cover capital expenditures, dividends and debt repayments

OCF with relatively low volatility »

There is a very good book to read about cash flow analysis, from Charles W. Mulford and Eugene E. Comiskey, Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance, Hoboken, NJ: John Wiley & Sons, 2005.

It’s a very good read (I read it a long time ago and not surprisingly, it’s in the bibliography of the reading).

The idea is that you have to be careful with how companies have to ability to reclassify cash-flow statement (permitted by IFRS for instance) and make sure there is consistency in such a reporting and classification.

Balance Sheet Analysis

This is probably the trickiest part for an analyst but one of the most important financial statement, but sometimes overlooked by investors.

Here the curriculum takes the reader through the idea of B/S completeness, unbiased measurement and clear presentation.

High quality B/S are proven by optimal capital structure and amount of leverage (historically and in comparison with the industry), adequate liquidity, and intelligent capital allocation – a quality very few CEOs have.

B/S analysis will of course be completed by looking at the other financial statements and the reading of financial notes which are very important.

The usage of off-B/S items, the way equity investments and JVs are consolidated in the company’s B/S may have an impact on its completeness.

The same goes with how management measures the value of assets and liabilities. Some key items to look at specifically include: impairment charges for specific items (goodwill, inventory); deferred tax assets and liabilities; pension liabilities and the underlying assumptions to evaluate them.

This is just but a summary of all the items investors should pay attention to before they start crunching numbers and stack them up into excel spreadsheets to arrive at the intrinsic value of a company.

Having a sound process to analyze all the above mentioned items is probably the best way to start your investing journey soundly and find your way to financial success.

Most of the remarks in this note are derived from one of the reading in the CFA Level 2 curriculum that I’m currently taking. If you’re really interesting in investing and have time and money to spend, you should definitely consider taking CFA examination. At least, you learn tons of interesting stuff.