Earnings Quality and Cash Flow Analysis

Earnings Quality and Cash Flow Analysis

Earnings quality refers to the persistence and sustainability of a firm’s earnings. Earnings that are closer to operating cash flow are considered higher quality. Of course, earnings are subject to accrual accounting events that require numerous judgments and estimates.

As a result, earnings are more easily manipulated than cash flow.

We can disaggregate earnings into their cash flow and accruals components using either a balance sheet approach or a cash flow statement approach. With either approach, the ratio of accruals to average net operating assets can be used to measure earnings quality. The interpretation of both ratios is the same: the lower the ratio, the higher the earnings quality.

Accruals Ratio

Balance sheet approach. Using the balance sheet, we can measure accruals as the change in net operating assets over a period. Net operating assets (NOA) is the difference between operating assets and operating liabilities.

Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short term and long term). In summary, the formula for balance sheet based aggregate accruals is:

In order to make comparisons, it is necessary to scale the accrual measure for differences in size. Just like ROA and ROE, the measure can be distorted if a firm is growing or contracting quickly. Scaling the measure also allows for comparisons with other firms.

Scaling is done by dividing the accrual measure by the average NOA for the period. The result is known as the accruals ratio:

Cash flow statement approach. We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows:

The purpose here is to evaluate the persistence and reliability of earnings by calculating accruals as a percentage of net income. (Higher accruals indicate less reliability.)

Net income arises from transactions associated with CFO and CFI: CFO represents profit from our normal operating business, and CFI represents income from investments in other businesses.

CFF, however, arises out of decisions about how the company’s operations are financed.

Recall that IFRS allows some flexibility in the classifications of certain cash flows, primarily interest and dividends paid. Thus, for firms following U.S. GAAP, it may be necessary to reclassify these cash flows from operating activities to financing activities for comparison purposes.

Like the balance sheet accrual measure, the cash flow measure must be scaled for comparison purposes. Thus, the accruals ratio based on the cash flow statement is:

Figure 12.14 contains the necessary data to calculate the accruals ratio using both approaches.

Figure 12.14: Selected Balance Sheet and Cash Flow Data

Using the data contained in Figure 12.14, we can calculate the balance sheet and cash flow statement accruals ratios in Figure 12.15.

Figure 12.15: Balance Sheet and Cash Flow Accruals Ratios

Under the balance sheet approach, the accruals ratio has fluctuated widely over the period, from 17.3%, down to 8.2% in 2022, and back up to 16.6%. Wide fluctuations like these may be an indication of earnings manipulation.

Equally disturbing, the accruals ratio calculated using the cash flow approach has steadily increased over the last three years from 5.6% in 2021 to 19.7% in 2023.

Because of the potential for earnings manipulation by increasing accruals, we decide to compare Thunderbird’s cash flow to its operating income. Our interest is in determining whether operating income is confirmed by cash flow. However, we cannot directly use the cash flow from operating activities as a proxy for cash flow for this purpose.

In order to compare the two measures, it is necessary to eliminate cash paid for interest and taxes from operating cash flow by adding them back. (Interest and taxes are deducted for operating cash flow but not for operating income.) This adjusted figure is the cash generated from operations (CGO). CGO can also be calculated as:

As shown in Figure 12.16, we can calculate the ratio of cash generated from operations to operating income.

Figure 12.16: Cash Flow to Operating Income

The ratio of CGO to operating income confirms that cash generated from operations has exceeded operating income over the past three years. The results of this analysis reduce our earlier concerns of potential earnings manipulation from our accruals analysis.

In order to evaluate Thunderbird’s recent acquisitions, we examine the cash return on total assets.

Figure 12.17: Cash Return on Total Assets

The cash return on total assets has increased over the period, which seems to justify the recent acquisitions. However, since the results of the accruals ratios, calculated in Figure 12.15, gave us cause for concern, we need to calculate cash flow to reinvestment, cash flow to total debt, and cash flow interest coverage ratios.

Figure 12.18: Selected Cash Flow Ratios

All three cash flow measures presented in Figure 12.18 are reassuring. Although cash flow to reinvestment declined slightly over the period, cash flow still covered capital expenditures by 3.6 times in 2023.

This indicates there are sufficient resources to fund Thunderbird’s ongoing capital expenditures.

Cash flow to total debt of 56.4% in 2023 confirms Thunderbird’s relatively low leverage. Cash flow interest coverage (the interest coverage ratio calculated on a cash flow basis) has been declining over the past three years but, for 2023, cash flow still covered interest paid 21.9 times, which is excellent. With low leverage and high interest coverage, Thunderbird has the flexibility to increase its debt if the need arises.