How to identify quality earnings?

What is earnings quality and how to identify earnings manipulation?

Introduction

In this blog, we will discuss about an important aspect of fundamental analysis i.e earnings quality.We will also take a look at how one can spot the earnings manipulation in company’s financial statements.

How to identify quality earnings?

We can gauge the quality of earnings by looking at the financials of the company.

Cash-flow

• Cash-flow of the company mainly comes from three activities as shown:

• To identify the earnings quality, one should start with company’s operating cashflows.
• Cash-flow from operations (CFO) mainly comes from core business operations that includes mainly core operating revenues and working capital changes. For example, in case of HUL, majority of its sale should come from sale of FMCG products, which is its core operating activity.
• Ideally cash flow from operation should majorly consist of core operating revenue rather than other income or one time gains on investment.
• If company has a major chunk of revenues coming from other income and one time gains on investment, it is not a sustainable source of earnings.
• Similarly,Cash-flow from investing (CFI) includes mainly the cash outflow/inflow of company when it buys a new plant/building/machinery, receives interest/dividends on its investments , any acquisitions undertaken by company, etc.
• Cash-flow from financing (CFF) activity includes the cash inflow/outflow company undertakes to meet its financing obligations. This mainly includes dividend pay outs, interest payment on borrowings, costs incurred in issuing new share capital, etc.
• After adding the three components of cashflows i.e. CFO, CFI and CFF, we get net cash-flow earned by company in the given financial year.

Free cash-flow

• Another way to check the quality of earnings is by analyzing free cash-flow from operations. Free cash-flow of a company is obtained after deducting capital expenditures and dividends paid from cash-flow from operations.
• Free cash-flow from operations should match with net profit of the company and ideally should be greater than the net profits. Similarly, free cash-flow growth should be in line with the growth of net income.
• If the growth is consistent with these parameters, then it is said that company is on the path of sustainable growth. It also indicates that company is not undertaking any earnings manipulation.

Accounts Receivables

• Sometimes companies recognize revenue in their financial statements before receiving them. This will result in inflated revenues on company’s books leading to earnings manipulation.
• Also, sometimes company undertakes credit sales and recognizes it under accounts receivables. This is a part of current assets of the company.
• But it is important to check if the accounts receivables are getting converted to cash. There might be a chance that company sold its products on credit to some distributors. But never received the revenue for the products sold. This will turn some of the accounts receivables into bad debt.
• Thus, we should monitor the quality of accounts receivables on balance sheet and its increase should be in line with increase in operating revenues on QoQ and YoY basis.

Inorganic growth

• Another parameter to check is the inorganic growth of the company. A company basically expands its operations through two routes – organic and inorganic. Organic way is in which company undertakes capital expenditure and expands its capacity, purchases new machinery/plant/buildings, etc.
• Inorganic growth is when a company undertakes merger/acquisition of other companies. Due to this, it might happen that there can be a surge in revenues.
• One should analyze a company by taking into consideration the effect of merger/acquisitions on revenue growth.

Corporate governance

• Also, in addition to above parameters, if company is consistently meeting the revenue and profit expectations of market analysts , there is a chance that company is cooking its books.
• Corporate governance as a whole plays an important role in thoroughly analyzing a company before investing in it. Usually , MNCs and large corporates with brand legacy do not have corporate governance issues.