Earnings and Balance Sheet Quality and Financial Analysis - Financial Management

When performing a financial analysis of a firm, an analyst must be mindful of the quality of the earnings reported by a firm, as well as the quality of the firm’s balance sheet. These two dimensions of financial analysis can have a critical impact on the final assessment of the firm’s financial condition.

Earnings Quality

When considering the quality of a firm’s earnings, two key factors should be kept in mind. First, high -quality earnings tend to be cash earnings. The proportion of a firm’s earnings that can be viewed as cash earnings is greatly influenced by the firm’s procedures with respect to sales revenue recognition. For example, a firm may recognize a sale at the time a contract is signed, a down payment is made, or when the full proceeds from the sale are actually collected as cash. Generally, the closer the recognition of a sale is to the time the full proceeds from that sale are collected, the higher is the quality of the firm’s reported earnings.

Although there is frequently a close correlation between a firm’s earnings and its cash flows over time, generally accepted accounting principles give companies substantial latitude in the reporting of earnings. Distortions in earnings can arise from such issues as the time of revenue recognition, the establishment of reserves for such items as loan loss provisions in banking, the amortization of intangible assets, and the like. In times of business downturns, earnings often plummet while cash balances soar. For example, in late 2001 Texas Instruments saw its sales fall more than 40 percent relative to the same quarter in 2000.

It lost $120 million, compared with profits of $680 million a year earlier. Yet cash balances soared above $3 billion, some of its highest on record, due to cuts in capital spending and reductions in inventory. The company also saved substantial amounts from its profit-sharing arrangements with employees.The opportunities for abuse in earnings reporting can be readily seen in the case of Enron Corporation. In late 2001, questions began to be raised about some of Enron’s financial reporting practices. The stock plunged from in excess of $90 per share to less than $10 per share. On November 8, 2001, Enron reduced its previously reported profits since 1997 by $586 million and increased its previously reported debt levels by $628 million at the end of 2000.

The company admitted that it should have included in its consolidated financial statements results from three officer -run partnerships. On November 9, it was announced that Enron’s crosstown rival Dynegy would acquire this one-time high flyer of the energy world.15 As news of additional accounting irregularities came to light, the Dynegy merger was canceled. Shortly thereafter, Enron declared bankruptcy.

Another area of earnings reporting abuse is so -called “pro forma” profitability measures. They are computed by companies “as if” certain ordinary expenses did not exist. In one particularly abusive example,Waste Management treated the cost of painting its trucks as an extraordinary one-time expense and thus excluded this expense from pro forma earnings calculations.

A firm’s earnings can be viewed as high quality if a greater proportion of those earnings is derived from regularly recurring transactions. To the extent that reported earnings reflect the impact of nonrecurring transactions, the quality of those earnings is reduced. For example, when Tenneco sold its oil and gas businesses, the company was able to recognize a gain of $892 million on the transaction because these businesses were carried on Tenneco’s books at an amount less than the total sales price.

This transaction is of a nonrecurring nature and should not be considered when evaluating the earnings capacity of the firm. Other similar nonrecurring gains can emerge when a firm repurchases its debt on the open market at a price lower than the face value of that debt. Also, a firm may change its accounting treatment of inventories and record a significant gain from this transaction. General Motors (GM) did this and reported a one-time gain of $217 million.16 Another example of a nonrecurring transaction from which gains can occur involves lowering the reported depreciation expense on a company’s existing assets.

When GM increased the length of time it depreciates auto plants from 35 years to 45 years, it reported a nonrecurring earnings increase of $790 million.17 Examples such as this can be found almost any week in The Wall Street Journal. The lesson from these examples is simple: The quality of a firm’s earnings decreases in direct proportion to the increase in nonrecurring items reported in its earnings figures.

Balance Sheet Quality

The quality of a firm’s balance sheet should also be of concern to a financial analyst. If the assets on a firm’s balance sheet have a market value equal to or greater than the book value at which they are being carried, this enhances the quality of the firm’s balance sheet. In contrast, if a significant portion of the assets of a firm has a market value substantially below book value, the quality of the firm’s balance sheet is reduced. Over the last decade, we have seen many firms in the so-called smokestack industries record large losses as significant portions of their assets are abandoned and written off as losses.

These firms include Kaiser Aluminum,U.S. Steel (USX), and Bethlehem Steel. Bethlehem Steel declared bankruptcy in late 2001, as it found its remaining assets could no longer generate adequate levels of profits and cash flows. Commercial banks regularly write off a portion of their loan portfolios when it becomes clear that particular loans will not be repaid. These actions greatly reduce a firm’s equity ratios. Similarly, if a firm has significant amounts of inventory that cannot be moved, the quality of the balance sheet is reduced until the firm charges off this lowquality inventory.

In addition to asset quality issues, an analyst should also be aware of hidden liabilities. These liabilities may take the form of such things as long-term lease obligations not appearing on the company’s balance sheet or uninsured losses arising from pending lawsuits. When large potential liabilities exist, an analyst must be quite careful before drawing conclusions about the adequacy of a firm’s capital structure, based upon an analysis of itsreported balance sheet.

In contrast, some firms have significant hidden assets. These assets may be physical assets, such as real property that has appreciated in value but is carried on the firm’s books at cost, or securities that are carried on the books at cost even though the market value of these securities has increased above the original cost. These hidden assets may also consist of intangibles, such as valuable patents or brand names.

For example, Philip Morris (now Altria Group) was willing to pay over 10 times the fair value of Kraft’s physical assets in order to obtain the brands (e.g.,Velveeta cheese and Miracle Whip salad dressing) and consumer loyalty that Kraft had spent decades building up.

This list of balance sheet and earnings quality issues is not all-inclusive, but it does give an indication of the extent to which a surface analysis of a firm’s financial statements can lead to misleading conclusions about the financial condition of that firm. As Professor Shyam Sunder of Yale has said, “Off-balance sheet financing is a nice, gentlemanly label given to misrepresentation.”

Good financial analysts develop an eye for this type of deception.

ETHICAL ISSUES

The recent accounting scandals involving such wellknown companies as Enron,WorldCom, HealthSouth, Adelphia Communications, and Tyco International, led to a crisis in investor confidence and a loss of faith in the reporting of financial results by corporations. Various proposals have been put forth to deal with these issues, some of which were codified into law with the passage of the Sarbanes–Oxley Act of 2002. The primary values of good corporate governance and financial reporting should include transparency, accountabilityand integrity.

Transparency.

Companies should be willing to provide information needed by their various stakeholders (e.g., shareholders, bondholders, customers, etc.) to make informed decisions. Information is transparent when it provides the user with a clear understanding of the results of the company’s operations —namely, its income and cash flows, assets and liabilities, and other aspects of its business.

Accountability. There must be a strong commitment to a culture of accountability among all the participants, including the board of directors, officers of the corporation, and its external auditors. Each individual must take responsibility for carrying out his/her role in the financial reporting process.

Integrity. Transparency and accountability depend on individuals trying to “do the right thing.” Doing what is expedient or even permissible is not acceptable. Integrity is the foundation for the various stakeholders being able to trust the information generated by companies.

The Sarbanes–Oxley law contains various provisions that seek to restore the public’s faith in the financial reports issued by companies. The act places responsibilities on the various parties involved in the corporate reporting process.

Audit committee.

The audit committee of the board of directors must consist of independent directors. At least one member of the audit committee must meet specified criteria as a “financial expert” and, if not, the reason for the absence of such a member must be specified.

Company executives.

The CEO and CFO must affirm the completeness and accuracy of the company’s quarterly and annual reports. Certifying a report that does not conform to the law subjects the officer to a fine of up to $1 million and a jail sentence of up to 10 years.

External auditors.

The external auditor is prohibited from providing any major nonaudit services to the company, such as bookkeeping, while performing the audit.

The Sarbanes –Oxley Act established the Public Company Accounting Oversight Board, under the direction of the SEC, to monitor compliance with the law. Whether this law will restore investor trust and confidence depends on many factors.

These include the qualifications and character of company directors, whether the directors remain vigilant, and the amount of information management shares with the board.As Nell Minow, editor of the Corporate Library, a governance research service, noted, “There is no structure that can’t be subverted.

The Sarbanes –Oxley Act and the Financial Reporting Processa

Irwin Ross, “The Stern Stewart Performance 1000,” Bank of America Journal of Applied Corporate Finance (Winter 1999):


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