Whether you are a corporate manager or an investor in the stock market, basic financial analysis is an imperative skill. When glancing at a statement of operations, revenue and earnings are typically the first items looked at. When public companies release quarterly earnings which slightly beat or miss expectations, stock prices can fluctuate greatly. Even for private companies, net earnings are perhaps the most significantly followed metric of performance. While the gross amount of earnings clearly matters, it is important to also assess the quality of the earnings. The following items are a few signposts of poor earnings quality which may affect your business or the businesses you invest in.
- Non-cash earnings: the general purpose of accrual-basis accounting is to paint a more realistic picture of company activities on financial statements. However, one should pause when earnings increase despite increasing receivables and stagnant operating cash flows.
- Non-recurring events: all legitimate sales count, but recurring, organic sales growth are the key to future performance. Large, infrequent events may not be indicative of a company’s prospects.
- Changes in accounting estimates: a key accounting estimate that often first comes to mind are costs related to the percentage of completion, but another example may be discount rates for lessors. If a lessor decided to lower the interest rates by which lease sales were discounted (more revenue now, less interest later), earnings would rise without an underlying economic change.
This is a short list, and there are certainly more aspects to earnings quality which can be considered. Still, hopefully this helps you get in the mindset of considering earnings quality in assessing your company financials or other public companies for investment purposes. More earnings are desirable, of course, but it is important to consider the quality of earnings as well.
Michael Veldhuizen, CPA