To compute the quality of earnings ratio, first subtract “cash from operations” from net income. You can find both items on the income statement in a quarterly or annual report. Then divide the result by “average total assets.” You compute this by averaging the amount of assets on the balance sheet at the beginning and end of the year.

 

 

 

Dear Collective,
Wanting to begin taking my mind off recent events, and do something productive – went through some articles I had saved and decided to reread this one by Michael Brush (MSN MoneyCentral contributor):

http://moneycentral.msn.com/articles/invest/company/7129.asp?Printer

A guide to telling if company earnings are of good quality. As you know TMF writer's don't pay much attention to earnings, focusing instead on Cash and Cash Flow. Having been schooled in NAIC teachings as well as TMF, I do pay attention to earnings. Earnings are what in the long run will drive the price of the stock. I do understand that earnings can be “manipulated” on the balance sheet . This article provides some of the items to look for in order to test the quality of earnings, and a simple tool – they refer to as the “Catch-All Quality of Earnings Ratio" that can be used to quickly look for potential “shenanigans.”

Here is an outline of the things to look for to test the quality of earnings, and an example of the “Catch-All Quality of Earnings Ratio using LLY:

Watch for accounts receivables rising faster than sales. Accounts receivable measures the amount of outstanding bills a company has to collect. A buildup here signals that a company is booking revenue more aggressively or relaxing credit standards to meet its earnings numbers.

Watch for inventories rising faster than sales. Likewise, this is a potential sign that sales are becoming harder to come by. “This usually suggests inventory is aging, rather than that a company is building inventories in anticipation of higher sales,” says Sloan. You can calculate this measure the same way you calculate receivables to sales.

Look for companies that are capitalizing expenses aggressively. By booking an outlay as a capital cost (an asset), a company avoids chalking it up as an expense that hits earnings. Companies are often allowed to do this.

Look for 'cookie jar' reserves. Companies regularly set up reserves against doubtful accounts, or potentially bad debt. But some firms build them up high in good times, stashing away cash to be used when times get tough, or else draw them down too much when they are having trouble meeting earnings, says Olstein. So it's important to watch for unusual changes in the percentage of reserves compared to receivables.

Compare levels of reserves, receivables and inventories to industry standards.

Watch for the use of non-recurring gains to support earnings growth. This is a favorite of Jack Ciesielski, who publishes the Baltimore-based Analysts' Accounting Observer. “See how much of the earnings improvement is coming from the pension plan,” says Ciesielski. (It's usually explained in annual report footnotes.) Companies may also use stock portfolio sales, or the sale of a subsidiary, to meet earnings growth expectations.

Look at the difference between what a company is telling shareholders about earnings, and what it is telling the Internal Revenue Service. Some companies keep two sets of books, one for shareholders and one for the Internal Revenue Service -- a generally acceptable practice. However, it's important to look for differences between the two in quarterly reports' tax reconciliation footnotes.

The simple annual report size test - This is an interesting one – Merrill Lynch researchers found that the larger a company's annual report the worse the stock performs.

The “catch-all” quality of earnings ratio.

Instead of hunting around in individual accounts in the financials, one easy way to look for potential shenanigans is to use a “catch all” quality-of-earnings measure. The beauty of this test is that it picks up potentially managed earnings anywhere on the financials. “You are better off using an aggregate measure because often if a company is managing earnings, they are doing it in many accounts,” says Sloan.

Essentially, with this test you're doing what all good accounting sleuths do: Looking for a divergence between net income -- or reported earnings -- and cash flow.

If net income is growing faster than cash flow, then the company is using something other than hard cash to produce the earnings growth. If that something else is accounting sleight of hand, then problems may be around the corner. “The bigger the gap between the net income and cash, the lower the quality of net income and the higher the chances a company is managing earnings,” says Sloan.

To compute the quality of earnings ratio, first subtract “cash from operations” from net income. You can find both items on the income statement in a quarterly or annual report. Then divide the result by “average total assets.” You compute this by averaging the amount of assets on the balance sheet at the beginning and end of the year.

When the ratio is below -.10, according to Sloan's research, the company has high quality earnings. Its earnings are backed by a lot of cash. If the answer is greater than .03 to .06, the quality of earnings is questionable.

Your next step is to figure out which account -- like inventories or receivables -- is causing the difference, and whether it is really a problem. Remember, there may be an innocent explanation.

“In the long run, earnings have to be supported by cash flow, or there will be trouble,” says Sloan. “An asset, like inventories or receivables, is simply an expected future cash flow. When we see those assets slipping out of control relative to sales, it identifies situations where that asset may not produce the expected flows.”

LLY Example:
Question: I'm assuming Income from Continuing Operations is the same Cash From Operations? I saw nothing on the Income Statement identified as Cash From Operations? Am I correct here? The definition from MSN MoneyCentral for Net Cash From Operating Activities = The sum of net cash from continuing operations and net cash from discontinued operations (LLY had no discontinued operations).


Income from cont. operations 3057.80 minus Net Income 3057.80 = 0
Total Assets: FY 2000 1469.80
FY 1999 12825.20
Average Total Assets: 7147.50
Dividing the result of 0 by the Average Total Assets of 7147.50
Quality of Earnings Ratio = 0

This indicates that LLY's Quality of Earnings Ratio being less than .03 to .06 the company has high quality earnings. Its earnings are backed by a lot of cash.

OK, now Collective did I compute this correctly? If I did (hopefully) – what do you all think of this tool – seems easy enough to calculate.

Regards - Ev