Financial Analysis & Valuation

Assessing the Quality of Earnings

(and remaining items)

FBE 421 – Scott Abrams – Spring 2023

42

Techniques for Financial Analysis

 Financial health
 Common size financial statements
 Ratio Analysis
 Analysis of the statement of cash flows
 Off balance-sheet exposure
 Performance Evaluation
 ROE and the DuPont analysis
 ROIC
 FCF vs. Earnings
 Analysis of revenue growth
 Risk analysis
 Quality of management

FBE 421 – Scott Abrams – Spring 2023

43
 Cash Flow is King (or is it earnings?)
 Performance Evaluation
 Ideally we want both CF and earnings, but earnings gets the emphasis

 Equity Valuation
 Both are used again, but CF gets the emphasis

FBE 421 – Scott Abrams – Spring 2023

44

Are Reported Earnings Important? How Do We

Assess the Quality of Earnings?
 Firms create value by implementing projects that have positive NPV
 Managerial decision making is complicated by near-term earnings and performance
pressures. It is not unusual for managers to pass up positive-NPV investments that would
temporarily reduce their firm’s earnings
 “You can’t grow long-term if you can’t eat short-term.” - Jack Welch, former long-time CEO
of GE
 Short-term earnings goals may incorrectly influence investment decisions
 Managers take their firm’s earnings numbers very seriously and are aware of how a major
investment influences their reported earnings in the short run as well as the long run.
 Cash flows of an investment are almost never evenly distributed over the life of a project.
 The quality of earnings can be assessed by the degree to which a firm’s accounting profit
has support in cash flow (ratio of cash flow from operating activities to net income)

FBE 421 – Scott Abrams – Spring 2023

45
Earnings Manipulation
 A careful analysis of a firm’s financial statements can also help uncover
evidence of earnings manipulation by the firm’s management.
 Earnings are sometimes manipulated by managers to paint a rosier picture of
firm performance.
 In some instances, the manipulation is simply designed to smooth out reported

earnings, while in others it is designed to fraudulently disguise the firm’s true

performance.
 100 straight quarters of rising earnings per share at General Electric (GE) under the
leadership of CEO Jack Welch
 Worldcom’s earning manipulation through capitalizing costs that should have been
expensed in the current period

FBE 421 – Scott Abrams – Spring 2023

46

Can we rely on current earnings as a good

predictor of future earnings?
 Check for areas of accounting flexibility
 revenue recognition, expense recognition, inventories, PP&E, goodwill

 The firm’s particular circumstances?

 Material non-recurring gains and losses?
 Material changes in receivables and inventory?
 Major differences between CFO and net income?
 Change in gross margins?
 Changes in other expense relationships?
 Discretionary cash expenditures slowed down?

FBE 421 – Scott Abrams – Spring 2023

47
Can we rely on current earnings as a good
predictor of future earnings?
 Is the firm capitalizing items that are normally expensed by other firms in the
industry?
 Material risks, uncertainties or contingencies that might negatively affect future
earnings?
 Non-standard audit report?
 Unusual pattern in segment numbers? In quarter-to quarter numbers?
 Are the firm’s sales dependent on a single customer? Are its costs dependent on a
relationship with a single supplier?
 Sales backlog?
 Payables building up? Debt building up?

FBE 421 – Scott Abrams – Spring 2023

48

Tricks management can use to distort financial

performance
 Overstating revenues
 Understating operating costs
 Misuse of restructuring charges
 Selective triggering of one-time gains
 Hiding debt
 Changing accounting estimates

FBE 421 – Scott Abrams – Spring 2023

49
Example ~ using restructuring costs to smooth
earnings
Year 1 2 3 4

Cash flow from operations
before cash paid for restructuring            1.0            1.2            5.0            0.3

Less: cash paid for 
restructuring            ‐            ‐            ‐           (2.0)

CFO            1.0            1.2            5.0           (1.7)

Restructuring costs accrual (balance)            ‐            ‐           (3.5)            3.5

Net income            1.0            1.2            1.5            1.8

FBE 421 – Scott Abrams – Spring 2023

50

Earnings & Accounting Manipulation ~

Notable cases:
 Waste Management (1998): reported fake earnings of $1.7B by manipulating
depreciation
 Enron (2001): kept debt off the balance sheet
 Worldcom (2002): $3.8B in fraud; capitalized expenditures that should have been
expensed, inflated revenues with fake accounting entries

FBE 421 – Scott Abrams – Spring 2023

53
Analysis of Growth
 Increasing market share
 Raising prices
 Selling new products or services
 Acquiring another company
 Favorable currency effects
 Accounting change

FBE 421 – Scott Abrams – Spring 2023

54

Assess the Quality of Management

 Overview  Turnover
 Character  Strategy
 Experience  Candor in Disclosures

FBE 421 – Scott Abrams – Spring 2023

55