Bad earnings quality can be an unintentional outcome, and therefore, we are not judging management intentions but judging the reliability and sustainability of the reported figures.
This is not an exhaustive list of all the things we look for when performing an earnings quality analysis, we adapt to circumstances:
First, how can we understand the company?
- We read almost everything we can on the company for several years, annual reports, business presentations, webcasts. We assist to analysts presentations, we talk to people working in the sector, we talk to competitors.
- We use some simple checklists:
- we think and process information using Porter’s competitive and structural analysis (Porter’s five forces).
- We think in terms of critical success factors: what are the key jobs (or factors) management must deal with in order to make the company succeed.
- We think in terms of SWOT (Strengths, Weaknesses, Opportunities and Threats) with a particular emphasis on risks.
- We do the same analysis for several competitors and we get different perspectives on the same industry
- Are competitors retiring from some sectors, selling assets or stopping some activities and why?
Then how can we form an opinion on the company’s earnings quality:
- Is the business properly described by the accounting:
- Does the company easily record revenue in advance? Does the company restate the figures it recorded in advance?
- Can we understand, in terms of business operations, why there are differences between earnings and cash flows? Do earnings stem from cash flows or accruals?
- Accruals such as provision reversals which are inherently non-recurring?
- Do we find some significant accounting differences when looking at competitors?
- Do we found working capital red flags:
- Is the company stretching out payables and does this situation seem sustainable?
- is the inventory of finished products building-up?
- Is the company extending its trade receivables with no commensurate increase in allowances for doubtful accounts?
- Large increase in receivables could result from lower credit standards, is the company booking revenue aggressively?
- Capex
- Is new management unduly reducing capex in order to present a higher free cash flow?
- Is the company’s capitalization of expenses dubious?
- Non-recurring
- Is the company improperly recording recurring charges in the non-recurring category?
The list goes on and on…there is no single checklist to found earnings quality issues. The proper attitude is to read the reports, be focused on understanding the business economics and its corresponding accounting, being curious and using common sense.