How should you gauge quality of earnings? Why is it important?
Ideally, investors would always want to have access to financial reports that are based on sound financial reporting standards and which are free from manipulation. However, in practice, the quality of financial reports can vary greatly across companies, and therefore, earnings can be manipulated by accounting tricks, one-time items, or anomalies. In this article, we will understand the concept of quality of earnings (QoE) and how you, as an investor, can gauge the quality of earnings.
Why is it needed?
It is easy for a company to manipulate earnings by using various accounting conventions. Some manipulate earnings to lower their tax liability while others do it to make the company look attractive in the eyes of investors & analysts.
A company can manipulate earning measures such as the popular price-to-earnings ratio (PE ratio), widely used by retail investors. They can do this by buying back shares so that it can reduce the number of shares outstanding and boost the EPS artificially. When the EPS goes up, the PE comes down thereby, suggesting that the stock is undervalued. This could lead investors into believing that the company is sound and give a wrong signal to the market. Companies that follow such practices do not have high-quality earnings and thus, to assess the true position of the companies in these cases, it is necessary to look at the quality of earnings.
How to gauge the quality of earnings?
Calculating earnings quality is completely subjective and its accuracy depends upon the expertise of the person or agency calculating it. One way to look at quality earnings is by looking at how much money a company generates from its core operations alone. Net income may not always represent the true financial picture of a company. There may be some companies that have a massive net income, but negative operating cash flows. This is never a good sign because it indicates that a company is generating income through ways other than its core operations, which are unsustainable in the long run.
There is a ratio an investor can use to help with the above problem. It is dividing the net cash from operating activities by the net income. We can get the net cash from operating activities from the cash flow statement, while the net income figure is there in the income statement. This is known as the quality of earnings ratio.
Quality of earnings ratio = Net cash from operating activities/net income
Typically, if this ratio is less than one, then it means that net income is greater than operating cash flows and suggests that the company may be using accounting techniques to inflate the net income. On the other hand, a ratio greater than one, would suggest a better QoE.
Many times, it is seen that companies recognise revenue in their financial statements before receiving them. This is a common practice and the revenue recognised in these cases flows into accounts receivables before getting converted to cash at a future date. It is important to keep an eye on this number as there can be cases where a company has sold its products on credit to some distributor but have never received the revenue for the products sold. In time, these receivables turn into bad debt. So, an investor should monitor the quality of accounts receivables on the balance sheet and ensure that any increase in accounts receivable is in line with the increase in operating revenues on a QoQ and YoY basis.
Other than the methods mentioned above, another item one should be on the lookout for are the one-time transactions, or the non-recurring income or expenses. For example, a company may be able to postpone a debt expense by arranging a future balloon payment. Such an arrangement will increase the net income for the current period but may be of concern to the investors. Similarly, if non-recurring losses or expenses are repetitive over the years, it suggests that these losses are corrections to historical financial statements.