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When it comes to earnings, it’s a case of quality as well as quantity, says Peter Webb

When companies report financial results, the markets seem to focus on earnings. As an investor it is important to understand that not all earnings are created equally. Therefore, when you look at a set of results, you should also focus on the quality of those earnings.

What is earnings quality? Unfortunately there is no handbook for earnings quality but there are several factors you can use to determine how good companies’ earnings are. Are the earnings coming through to cash flow? Are profits being generated through core operating activities? What accounting policies are in use and are they prudent?

How does your cash flow grow?

You should generally expect cash to grow in line with earnings. Generating cash is critical to any company; cash repays debt and excess cash can be given to investors or re-invested in the business. If cash is not flowing into the company then it is likely something is wrong. Earnings growth can easily be achieved by aggressively writing off your cost base. While this will improve earnings, it will not improve cash flow. Creating an exceptional write-off or fiddling with balance sheet items may radically improve your profitability but may not solve any underlying issues within the business. It’s pretty obvious that if a company uses aggressive accounting techniques, it is likely to have lower quality earnings. The more a company turns to aggressive accounting techniques to massage the figures, the more likely it is that the underlying economics of the business are struggling. If the company’s fortunes do not turn around then the company is likely to run out of room for manoeuvre and problems will follow.

With a little help from my friends

Another way for companies to have growing earnings without cash flow is to have associate or related companies contributing to their overall profits. Associates are companies in which the holding company – the company whose report you are looking at – holds a minority stake in another company. Below a certain percentage, it would only recognise dividends from this company. Above a certain percentage it would have to integrate the associate’s accounts fully. In-between these areas, it is still obligated to report its share of that company’s profits in its accounts despite the fact it doesn’t actually own that company outright.

From the margins

In the illustrations provided, you can see similar companies with similar turnover generating similar profits but in different ways. In these examples, company B is focused on its core business and as a consequence is a market leader. Company A, however, has quite a spread of business in different markets and different geographies.

Looking at both, the immediate difference to note is that its operating margins are much stronger for Company B. By this we mean that its operating profit as a percentage of turnover is much better than its comparison. Company A also has additional income from associates. This income is not deliverable to shareholders in cash terms, only in accounting terms. Only if a dividend is paid by this associate will cash flow to the holding company. Investment income is also delivering a fair contribution to overall profit and therefore this needs examining as to why this is the case and how this income is being generated.

Taking exception

Company A has had two years of exceptional charges. If these charges were exceptional would these really occur in a row? It is possible that the company is overpaying for acquisitions, capital expenditure or other core costs and then having to write down these purchases to more realistic levels?

Interest costs are higher for company A than company B and this should also be examined. Is Company A using a lot of leverage to generate its profits? Examining how the company is funded is pretty straightforward – the balance sheet can provide most of these answers, as it is the balance sheet that reflects the source and use of funds.

Comparing these two examples also throws up some qualitative issues. With company A, a lot of profit as a percentage of total profit is coming from a non-core business. Is this sustainable and is the company too reliant on this, perhaps unfocused on the core business?

Comparing the two, company B is clearly better in terms of earnings quality. If we assume that they both issued the same amount of shares, earnings per share would be similar for both but the underlying characteristics are clear. If I had to invest in either, despite the fact that both ‘earn’ the same amount, company B would get my vote.

It is important to look at earnings quality as it tends to relate to better investment returns over time. You can benefit from this characteristic by making sure you look not just at earnings when you read a report but their overall quality too.