Assessing the Quality of Earnings

A critical aspect of any valuation analysis is the appraiser’s ability to read, understand and interpret a Company’s financial statements – a skill vital to making an accurate assessment of the value of any company. This is because most valuation methodologies incorporate adjustments to value based upon facts discovered during the course of the appraisal process, many of which relate to the Company’s financial statements. In addition, the appraiser is trying to assess the quality of the company’s historical and projected future earnings, which in most companies is a key component of valuation.

What are some of the basic factors an analyst or appraiser must assess in the analysis of the quality of a company’s earnings? The following items are not all-encompassing, but discusses a few balance sheet and income statement considerations appraisers examine in the determination of earnings trends and quality.

Receivables

Receivables on an upward trend can be the result of rising sales, or can be an indication of slow collections, or an acceleration of future sales. If a company’s revenues are growing rapidly, it naturally follows that a higher level of receivables can be anticipated, which is positive. However, a high level of receivables can also be an indication of a longer collection period which can be caused by a number of factors including internal organization problems (the absence of a collections person or department), factors related to the customer base which may be slowing payments (such as bankruptcies or financial difficulties), or an economic slowdown in general. The company could also be accelerating future revenue by offering incentives and price cuts to customers if purchases are made early. One of our recent clients with increasing receivables noted that it was a result of a combination of factors including rapid growth, the lack of proper administrative attention to receivables and a large account with a government agency that tended to be slow pay.

Inventories

Swelling inventories may be an indicator of a number of factors, not all of which are necessarily negative. High growth companies tend to have rapidly increasing inventory levels (which are necessary to accommodate increased sales). However, this could be a warning sign, depending on the nature of the business. Stockpiles of perishable inventories or those that become obsolete quickly may present a problem given a rapid downturn in sales or the development by a competitor of a better product. High inventory levels represent the potential for decreased production or a need to decrease prices to move inventory (which will affect gross margin).

An appraiser should compare balance sheet inventories (which represent a picture of inventories at a point in time) with the average inventory turnover ratio (which is a better measurement of how inventories have moved during the course of the year). Inventory turns should also be compared to similar companies in the industry for an accurate picture. A current client who manufactures very large machinery sometimes has a significantly higher level of inventories at the end of its fiscal year if it has recently completed the manufacture of a couple of machines that will be shipped in the next year. However, its inventory turns are comparable to those in the industry.

Fixed Assets

Trends in a company’s property, plant and equipment are typically examined to determine whether capital expenditures have been deferred and if significant expenditures can be anticipated. If this is the case, financing is generally required (which will increase debt service and impact earnings). Recent increases may be an indication of recent expenditures to accommodate growth or to upgrade property or equipment (which will affect cash flow). Information contained in the cash flow statement indicates annual capital expenditure requirements or those that may be necessary on an ongoing basis. If a significant decrease in the trend of capital expenditures occurs, it could be interpreted as neglect or deferred expenditures. Appraisers typically adjust cash flow and earnings proxies for known upcoming capital expenditures and the associated depreciation.

Revenue

“What constitutes revenue and when and how is it recorded?” is an important question asked by appraisers. Revenue recognition practices may distort a company’s revenue. Sales of customized products or services that require additional consulting services to adapt the product or service to the needs of the user after the sale may not be recorded in full immediately upon sale or shipment. If the sale is subject to returns or rebates, a reduction in sales should also be recorded. Service and construction companies record revenues either on a completed contract method (revenues and costs are recorded upon completion of the project) or the percentage of completion method (revenues and costs are recorded based on the portion of the work completed at fiscal year end). Appraisers watch accelerating revenues. Revenue received as the result of deep discounts can adversely affect future projected revenue. The keys are to understanding what actual recorded revenue is, reading the notes to the financial statements about revenue recognition policies and/or asking the client for a detailed explanation about how revenues are recorded. One of our clients recently changed its method of revenue recognition from the completed contract method to the percentage of completion method resulting in a significant nonrecurring charge to earnings.

Pension Plan Expenses

Companies with defined benefit pension plans must record expenses for projected future benefits. The determination of this cost is complicated and is dependent on a number of assumptions and facts including projected future benefits, the expected return on plan assets, interest costs, gains and losses in the plan, and amortization of prior service costs. The assumptions in this calculation, if not realistic, can inflate earnings by putting less in the plan than is necessary to meet future obligation. The footnotes to the financial statements usually contain these calculations and are a starting point to determine whether the assumptions are reasonable. If they are not reasonable, the appraiser can make adjustments to a company’s earnings to normalize pension plan expense.

Gains on Asset Sales

Specific types of companies have recurring gains or losses on asset sales (particularly those with rolling stock or equipment that must be replaced to keep the assets in good condition). However, this item of “Other Income” is examined closely by an appraiser to determine whether asset sales are recurring or if earnings have been distorted in any year by the sale of an asset which is considered nonrecurring. An asset sale, which is a sale of a significant segment of the business, may require deeper examination and a projection of earnings absent the segment. If a company has sold off a subsidiary in an effort to reduce debt, while interest expense may be less, the company may then be dependent on a mature, slow growing subsidiary which may negatively impact earnings going forward.

Nonrecurring Operating Items

Earnings are generally examined closely for nonrecurring expenses (or income) which will not occur again in the normal course of business. Sometimes this concept is not quite understood by appraisers or business owners. Some businesses tend to have a “series of nonrecurring events.” Identifying a nonrecurring event is sometimes tricky. The difference in extraordinary income related to a fire loss is clearly more easily recognized as nonrecurring than bad debt expense in a period of time when the economy is depressed. In a time of continual downsizing in many industries, restructuring charges or consulting expenses can not be considered nonrecurring when they tend to occur every year. Some gains or losses are appropriately adjusted for in prior years because they tend to result from problems a business experiences over a period of time. Fires, tornadoes and hurricanes are a sudden occurrence. However, slipping margins in a particular business segment as a result of increased competition and consolidation generally occur over time and, analytically, it may make sense to spread losses out over a period of years. For example, one of our clients recently reported a gain on the sale of a discontinued operation that had been draining earnings for a number of years, but also received insurance proceeds as the result of damage from a tornado. An adjustment was not made for the former because the net effect was that earnings would not change materially going forward because the company is now relying on a slow growth core business. The latter was considered a nonrecurring event.

Compressed Margins

An appraiser will always examine growth in revenues relative to growth in earnings. If the two are not growing in tandem and revenues are rising much faster than earnings, profit margins may be declining. On the other hand, if earnings are rising much more rapidly than revenues, an appraiser must question whether growth in revenue is sustainable or if earnings are the result of severe cost cutting measures. In other words, how will the factors that impact profit margins now affect them in the future?

These are just a few of the considerations analysts examine to determine the quality of a company’s earnings. There are certainly other factors that merit scrutiny such as tax planning, how a company calculates earning per share, stock options, research and development expenses and the impact of intangible assets. Understanding the quality of a company’s earnings is a critical component to any valuation, and the appraiser must have the knowledge and skill to assess the dynamics of the financial statements as a whole and the ability that is derived from experience to know when adjustments to earnings are warranted and when reported earnings are solid.

adapted from Mercer Capital

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By | 2017-04-27T17:13:57+00:00 February 26th, 2017|Business Valuation|Comments Off on Assessing the Quality of Earnings