Evaluating the Cash Flow Quality of a Company
The cash flow statement is used to identify areas of possible earnings manipulation since OCF is viewed as less subject to manipulation relative to earnings. An analyst should check for any unusual items or items that have not been present…
Indicators of Cash Flow Quality
The operating cash flow (OCF) is the cash flow component with the most direct impact on the valuation of a company. High-quality cash flow indicates that the company’s underlying economic performance was value-enhancing. Further, it implies that the information calculated…
Mean Reversion in Earnings
Recall from the previous section that earnings at extreme levels, both high and low, tend to revert to normal levels over time, a phenomenon called mean reversion. This is a typical characteristic of competitive markets. When a company realizes low…
Indicators of Earning Quality
High-quality earnings are characterized by sustainability and adequacy. Sustainability of high-quality earnings means that they tend to persist in the future, whereas adequacy implies that high-quality earnings cover the company’s cost of capital. High-quality earnings assume high-quality reporting. Furthermore, high-quality…
Sustainable (Persistent) Earnings
Sustainable (persistent) earnings are earnings that are expected to recur in the future. Non-recurring earnings are not sustainable and thus are low-quality earnings. More persistent earnings are more practical inputs for equity valuation models involving earnings forecasts. One way to…
Examination of the Quality of a Company’s Financial Reports
The M-score is the score indicating the probability of earnings manipulation. (Refer to the previous section for analysis of the model variables.) The M-score is a normally distributed random variable with a mean of 0 and a standard deviation of…
Evaluation of Financial Reports’ Quality
In an attempt to evaluate the quality of a company’s financial reports, an analyst seeks to answer these two questions: Are the financial reports GAAP-compliant and decision-useful? Are the earnings of high quality, meaning do they provide an acceptable level…
Potential Problems Affecting the Quality of Financial Reports
Measured amounts and timing of recognition and classification are the fundamental choices that result in possible issues that distort the quality of financial statements. Measured Amounts and Timing of Recognition Since financial statements are interrelated, one choice of a measured…
Conceptual Framework for Assessing the Financial Reporting Quality
The quality of financial reports can be viewed from two interrelated perspectives: reporting quality and earnings quality. Reporting quality is concerned with the information disclosed in financial reports. High-quality reporting provides decision-useful information. In other words, it includes information that is…
Analyzing Insurance Companies
Insurance company revenues include premiums and investment income on the float. Premiums are the amounts paid by the purchaser of insurance products, while investment income on the float refers to income earned on premiums between their collection and the payment…
