Monday, May 26, 2008

Analytical Review 101 – Part IV

Quality of Earnings Ratio

Let’s start with a quick quiz: What is the lifeblood of any business? [Highlight answer below]


Of all the figures in the financial statements, cash is the least susceptible to manipulation and creative accounting.

There are numerous techniques used to improve the cash flow position as at year end such as deferring payments to creditors, obtaining down payments from customers or aggressive debtors’ collection strategies. However, there is a limit to these techniques and Cash is still the most reliable gauge of the company’s overall performance.

The Quality of Earnings Ratio attempts to assess the quality of the Profit for the Year earned by the Company. In short, it assesses how much of the Profit for the Year has been successfully converted by the company into cash. Some of you might be scratching your head…

Remember this:

Remember, in order to convert the profit earned into cash, a company must collect all the debts owed to it by the customers. Some of these debts may not be collectible, hence resulting in bad debts. Inventories held by the company may be subsequently damaged or expire, resulting in additional inventory provisions. There could also be some aggressive earnings management (i.e. creative accounting) by the company to boost profits which is not sustainable. Therefore, it is critical to look at the Quality of Earnings ratio to assess the quality of the profits indicated on its’ financial statements. Let us review the components of this ratio.

Profit for the Year
We have discussed what the Profit for the Year represents earlier. In principal, it represents the gain made by the company for the sales of its’ products less all costs incurred by the company.

Net Cash from Operating Activities
This component represents the cash generated by the company during the year from its’ normal operating activities excluding investing and financing activities. Generally, this amount indicates the cash received from customers, payments to creditors & employees, cash tied up in working capital and income tax payments. A well managed company should have a very strong operating cash flow. Otherwise, the company may run into liquidity problems later on.

Analytical Review

For a company like Nestlé, a strong operating cash flow is expected. Such an established company with excellent brands should get very favorable terms from its’ customers. Most of its’ customers, comprising of established dealers and hypermarkets chains would not have problems paying their debts on time.

A review of Nestlé Quality of Earnings Ratio indicates that this ratio has been hovering, on average, at 100%. This is a strong indication that in terms of cash flows, the company is doing very well in managing its’ working capital and converting profits into cash. Nestlé has been exceptional in the management of its' cash flows.

Always check and review the quality of profits earned by the companies’ you plan to invest in. A strong Quality of Earnings Ration (close to 100%), indicates that the company is financially sound whereas a weak ratio (anything less than 80%) requires further detailed analysis of the divergence between profits and cash earned.


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