Quality of Earnings

Why this matters

A price-to-earnings ratio treats every dollar of earnings as equal. They aren't. A dollar earned from customers who paid in cash, in a business that can do the same next year, is worth more than a dollar that came from selling a building or changing an estimate. The previous module covered the accounting choices one at a time. This lesson combines them into a single judgment: how much of this profit can be relied on?

Three questions

Quality of earnings has no official definition and no single formula. In practice it comes down to three questions.

1. Is the profit backed by cash? Over time, a healthy business collects roughly what it reports.
2. Will it repeat? Profit from the ordinary business recurs. Gains from selling assets, tax windfalls, and accounting changes don't.
3. How cautious are the estimates? The same year can produce different profits depending on the assumptions behind reserves, depreciation, and revenue.

The same profit, twice

STU Corp, the fictional company from Part 3, earned $58 million this year. Company Z is also fictional and also earned $58 million on $400 million of revenue. Company Z's figures are hypothetical.

	STU Corp	Company Z
Net income	58	58
Cash from operating activities	84	20
Operating cash flow ÷ net income	1.45	0.34
Gain on selling a building, included in profit	0	15
Tax rate	21.6%	12.1%
Days of receivables, last year to this year	45.9 to 45.6	45 to 70
Capital spending ÷ depreciation	1.6	0.6

Every line after the first favours STU Corp. Its profit turned into more than its amount in cash, nothing unusual is included, its tax rate is ordinary, customers are paying on the same schedule as last year, and it's investing more than it's wearing out. Company Z collected a third of its profit in cash, needed a property sale and a low tax bill to reach $58 million, is waiting much longer to be paid, and is spending less on its assets than they're depreciating.

Question 1: is it backed by cash?

The simplest test is operating cash flow divided by net income, looked at over several years. Because depreciation is added back, the ratio is normally above 1 for a company with physical assets. A ratio that stays well below 1, or keeps falling, means profit is piling up in receivables, inventory, or other balances instead of arriving as cash. Accruals and Working Capital showed where to look for the cause.

A second version measures the part of profit that isn't cash against the size of the company:

Accruals = (net income − cash from operating activities) ÷ average total assets

STU Corp's is ($58 million − $84 million) ÷ $312 million, or −8.3%. Negative means it collected more cash than it reported in profit. If Company Z's assets average $330 million, its figure is +11.5%: more than a tenth of its asset base was added in profit that hasn't been collected. A large positive number isn't proof of a problem. A fast-growing company can have one for good reasons. It does mean the profit depends on balances that still have to turn into cash.

Free cash flow adds one more check, because operating cash flow ignores what the business has to spend to stay equipped. And as Stock-Based Compensation showed, pay in shares flatters cash flow, so it's worth subtracting.

Question 2: will it repeat?

Read down the income statement and the notes for anything that isn't the ordinary business:

• Gains or losses on selling assets, businesses, or investments.
• Restructuring charges, impairments, and legal settlements.
• Tax items, such as the release of a valuation allowance described in Deferred Taxes, or a rate well below normal.
• Gains from changing an estimate, such as a longer useful life or a smaller reserve.
• Income that isn't from operations, such as investment gains or currency movements.

Removing these, in both directions, is called normalizing.

	Amount
Reported profit before tax	66
Less: gain on selling a building	(15)
Profit before tax from the ordinary business	51
Tax at a normal rate of 21.6%	(11)
Normalized net income	40
Reported net income	58

About $18 million of Company Z's reported profit, nearly a third, came from a sale that can't be repeated and a tax rate that won't last. At a price of 15 times earnings, the difference between using $58 million and $40 million is $270 million of value. And $40 million still assumes the receivables are collected.

Be careful with charges that are labelled one-time but keep appearing. A company that records a restructuring charge in four years out of five has a recurring cost with an irregular schedule. The SEC's chairman warned in 1998 about "big bath" charges, where a company takes a large write-off in one go to clean up its balance sheet, which makes later years look better.¹ A practical approach is to add up the last five years of one-time charges and treat the yearly average as a normal cost.

Question 3: how cautious are the estimates?

This is the hardest to measure and often the most revealing. Compare the company's assumptions with its own past and with similar companies:

• Is the allowance for unpaid receivables shrinking as a share of receivables?
• Are assumed useful lives longer than at competitors, or recently extended?
• Are warranty and returns reserves falling while sales rise?
• Is the company treating more of its spending as an asset than it used to?
• Is the pension plan's expected return at the high end?

One loosened assumption means little. Several, all moving in the direction that raises profit, in a year when the company only just met expectations, form a pattern. Accounting Red Flags turns this into a checklist.

Management's own adjustments

Companies present adjusted earnings that are meant to do this job. They're a useful starting point, because the reconciliation lists the unusual items in one place. But the choice of what to remove belongs to management, which has more reason to take out costs than to take out gains. SEC staff guidance says that some adjustments can make a figure misleading, such as leaving out normal, recurring cash operating expenses needed to run the business, or removing a type of charge in one year but not similar charges in others.² Do the normalizing yourself, using the reconciliation as a list of candidates.

Key takeaways

• Equal profits aren't equally valuable. Quality depends on cash backing, repeatability, and the caution of the estimates behind them.
• Compare operating cash flow with net income over several years, and look at how much of profit sits in accruals.
• Remove gains, charges, and tax items that won't recur, then apply a normal tax rate.
• Charges that appear most years aren't one-time, whatever they're called.
• Use management's reconciliation as a list of items to consider, and make the adjustments yourself.

Check your understanding

Over five years a company reported total net income of $500 million and total cash from operating activities of $210 million. Revenue grew about 5% a year. What does that suggest?

1. Nothing unusual, because profit and cash are different measures and rarely match.
2. Much of the profit never arrived as cash, so the reported earnings deserve doubt.
3. The company is investing heavily, which always pulls operating cash flow down.

A company's adjusted earnings exclude restructuring charges, which it has recorded in each of the last six years. How should an investor treat those charges?

1. Exclude them, since the company has labelled each of them a one-time item.
2. Exclude them, since restructuring charges never involve any cash leaving.
3. Include a typical year's amount, since they've become a regular cost.

What's next

Low-quality earnings aren't always deliberate. Sometimes, though, the numbers are being pushed. Accounting Red Flags lists the signs that separate ordinary noise from something that needs a closer look.