Uncovering Genuine Earnings Performance: A Guide to Understanding Quality of Earnings
A company’s true quality of earnings can be seen only when anomalies, accounting maneuvers, or one-time events that distort the actual performance are removed from the figures. This purification reveals earnings ensuing from increased sales or reduced costs.
External factors such as inflation can also impact the quality of earnings assessment. During inflationary periods, many companies exhibit poor quality of earnings because their inflated sales figures paint a misleading picture.
In general, conservatively calculated earnings are more dependable than those inflated by aggressive accounting policies. Conversely, poor sales or heightened business risk can be submerged under dubious accounting tactics.
Generally Accepted Accounting Principles (GAAP) stand as the benchmark. Adherence to these principles typically results in higher quality earnings.
The significance cannot be overstated, as major scandals like Enron and Worldcom showcased extreme poor earnings quality that deceived investors.
Key Takeaways
- True earnings quality emerges after stripping away anomalies, accounting tricks, and one-time events.
- Quality of earnings is noted by the proportion of income arising from bona fide higher sales or reduced costs.
- Disparity between net income growth and lack of cash flow from operations is a warning signal.
- Tracking activities from the income statement through to the balance sheet and cash flow statement offers a valuable gauge of earnings quality.
Understanding How to Measure Quality of Earnings
One critical evaluation metric for analysts is net income. It offers a reference point for gauging company’s profitability. Higher net income compared to previous periods is initially seen as a positive sign, especially if it surpasses analyst predictions.
However, how trustworthy are these earnings? Companies can use varying accounting conventions to manipulate earnings, adjusting them upwards or downwards based on their motivations.
For instance, some companies might reduce earnings to lower tax obligations. Others might artificially inflate earnings to impress analysts and investors.
Companies manipulating their earnings are labeled as having poor or low earnings quality, whereas companies that refrain from such tactics enjoy high-quality earnings. Notably, even those committed to high earnings quality might still manage their financial information to optimize tax liabilities.
Adherence to GAAP standards is crucial, characterized by two fundamental qualities:
- Reliability: The information is verifiable, error-free, unbiased, and accurately reflects the transactions.
- Relevance: The information is timely, offers predictive power, and has awareness when making forward-looking decisions.
Practical Insights into Quality of Earnings Examination
Analyzing a company’s annual report offers many insights for gauging earnings quality.
Analysts typically begin from the top of the income statement and proceed downwards. For instance, high sales growth accompanied by high credit sales growth raises red flags. Analysts question sales driven primarily by lenient credit terms. (Variations in credit sales, also known as accounts receivable, can be found on the balance sheet and cash flow statement.)
Examining variations between operating cash flow and net income is another focal point. High net income paired with negative operational cash flows indicates that the earnings aren’t primarily coming from genuine sales activities.
Furthermore, significant one-time adjustments to net income are also suspicious. For instance, a company might alleviate expenses temporarily by refinancing debt into future payments, boosting net income in the short term while deferring debt repayments. Long-term investors react warily to such moves.
Example of Earnings Manipulation You Can’t Miss
A common manipulation involves artificially boosting popular metrics like earnings per share (EPS) and price-to-earnings (P/E) ratios through share buybacks—reducing the number of shares outstanding. Even with declining net income, the EPS could still potentially rise.
When EPS increases, the P/E ratio decreases, often misleading investors into believing the stock is undervalued. However, this perception fails when the true driver was merely share repurchasing.
The situation becomes even more unsettling if the company incurs additional debt to finance these share buybacks. Companies might do this to maintain or enlarge share prices through reduced market supply, falsely inflating perceived stock value.
Related Terms: net income, cash flow, balance sheet, income statement, earnings per share .
