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Assessing Earnings Quality: Potential Warning Signs
The investment community typically uses fundamental measures such as revenues, margins, and earnings to assess the performance of a company. In some cases, these more traditional figures can be good enough to decide the value of a corporation. However, one must also consider that companies can maneuver or massage their performance to meet near-term expectations, while prospects for success over the long haul are, in fact, diminishing. There are also some metrics that a company is not highlighting, intentionally or unintentionally, that may be indicative of lower profits in the future. By delving a little deeper into the financial statements, an investor can gain a better perspective of the company’s earnings quality and spot potential warning signs that do not always show up on the bottom line.
Inventory valuation is one of the more useful measures for a company that produces tangible products. It is also one of the more dynamic figures, making it particularly difficult to analyze. Inventory can fluctuate heavily from quarter to quarter, due to the seasonal rise and fall of demand and other timing and pricing issues. Moreover, very high or low inventory is not always a problem. For instance, most retailers stockpile inventory at the end of the third quarter to prepare for the seasonally strongest period of the year during the holiday season.
That said, a substantial unseasonal rise in inventory could be a bad sign. This may indicate that a company has a lot of unwanted product on hand. The result could be a broader decline in revenues due to lower demand moving forward. The company may also experience tighter margins, as it discounts these items heavily to shift toward a more-favorable product mix.
On the other end of the spectrum, a sharp decline in inventory may also be a bad sign when a company uses LIFO (Last In, First Out) inventory management. It may be the case that the input cost of inventory has risen sharply, and the company is dipping into its existing (older) supply of inventory, rather than purchasing new costlier items, to mask the rise in inflation. This, in turn, would temporarily lift earnings. However, the firm cannot do this forever; it will eventually have to restock its inventory with higher cost products. The result will be lower profit margins and weaker earnings moving forward.
More broadly, a sharp decline in inventory may indicate that the firm is strapped for cash or demand conditions are showing signs of deteriorating. Many companies experienced a significant decline in inventory to extremely low levels before the bottom of the recent recession. Investors must account for consensus demand and sales projections in conjunction with analyzing inventory trends.
Rising Accounts Receivable
Accounts receivable are revenues that were billed on credit, but payment has not yet been collected. Growing revenues and acquisitions could be a valid reason for a rise in accounts receivable; more business means that more items are billed on credit. However, if revenues are rising at a slower rate than receivables, this could be a problem. It means that a company is not as efficient in collecting payments. This could signify that the firm is seeking ways to bolster revenues by relaxing its credit arrangements or pursuing less financially sound customers.
Cash Flow Versus Earnings
Over the longer-term, free cash flow (operating cash minus capital spending) and earnings should be relatively similar if not the same. If the two figures lack consistency over a long span, it could mean that something is not right. Specifically, if earnings are exceeding free cash flow for an extended period of time, a company may be leaving out significant charges. There may also be off balance sheet items that are hiding potential bottom-line losses. In the scenario with Enron, cash flow was far below earnings because the company was hiding losses in special purpose entities that did not show up on the balance sheet. One way to measure this phenomenon is to use the accruals ratio (net income minus free cash flow divided by assets). A higher percentage indicates that cash flow and earnings are not matching up, and there may be a problem.
Shifting Discretionary Expenses
Discretionary expenses are those that a company can pick and choose to spend at a specific time. Commonly, a portion of R&D or SG&A costs are discretionary expenses. For example, a company can cut back on research or marketing overlays when it expects a decline in sales or profits in an effort to temporarily inflate earnings. This may be fine for the current period, but the decline may be unsustainable and disrupt future performance. Accordingly, it may be of interest for investors to track the pattern of expenses, such as SG&A and R&D, in conjunction with earnings. If discretionary expenses are cycling with demand, the company may be intentionally smoothing its performance.
These are just a few of a number of financial measures (mostly outside of the income statement) to look at when analyzing a potential investment opportunity. It should also be noted that just because a company may appear in violation of some of the aforementioned concepts, there may be a perfectly valid reason for it. As such, it is important to consider the bigger picture when making an investment decision.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.