# Issues Related to Balance Sheet Modifications, Earnings Normalization, and Cash Flow Statement Related Modifications on a Company’s Financial Condition

## Earnings Quality and Cash Flow Analysis

Earnings quality refers to the persistence and sustainability of a company’s earnings. High-quality earnings imply that a company’s accounting estimates are unbiased.

Additionally, it means that the earnings are derived from sustainable rather than non-recurring items.  Companies can try to make up for weak operating performance by manipulating accounting inputs. Earnings are easily manipulated relative to cash flows since they are accruals.

We can decompose earnings into cash flow and accrual components by focusing on the information in the balance sheet or the statement of cash flows. Using the latter gives a cleaner measure, i.e., free from the effects of non-cash acquisitions and foreign currency translation adjustment effects.

In the following section, we outline the two decomposition approaches and the accruals ratio for comparison of accruals with other companies.

## Accruals Ratio

### 1. Balance Sheet Approach

Under the balance sheet approach, we can define accruals as the change in net operating assets over the period. From the balance sheet perspective, we measure aggregate accruals such as the change in net operating assets (NOA) over the period for time t to t − 1.

$$\text{Balance sheet based aggregate accruals for time } t =\text{NOA}_{t}-\text{NOA}_{t-1}$$

Where:

$$\text{Net operating assets (NOA)}=\text{Operating assets}-\text{Operating liabilities}$$

$$\text{Operating assets}=\text{Total assets}-(\text{Cash and cash equivalents} + \text{Short-term investment})$$

$$\text{Operating liabilities}=\text{Total liabilities}-\text{Total debt (both short term and long term)}$$

The balance-sheet-based aggregate accruals must be scaled (deflated) by adjusting for differences in company size to make it comparable across companies. This makes the measure an adaptable indicator of earnings quality. The firm’s significant growth of contractions during the fiscal period can distort this measure. We can scale by dividing the accrual measure by the average NOA for the period. The result is known as the balance-sheet-based accruals ratio, which is given by:

$$\text{Balance sheet accruals ratio for time } t = \frac{\text{NOA}_{t}-\text{NOA}_{(t-1)}}{[\frac{\text{NOA}_{t}+\text{NOA}_{(t-1)}}{2}]}$$

### 2. Cash Flow Statement Approach

Here, we are looking at the difference between the reported accruals earnings and the cash flows from operating activities (CFO), and cash flows from investing activities (CFI). From a cash flow statement perspective, the aggregate accruals measure can be defined as:

$$\text{Cash-flow-statement-based aggregate accruals}_{t} = NI_{t}-CFO_{t}+CFI_{t}$$

IFRS allows some policy in the classifications of specific cash flows, primarily interest and dividends paid. Therefore, an analyst should reclassify cash flows from operating activities to financing activities for firms following U.S. GAAP. This enables useful comparisons.

The scaled measure, i.e., cash-flow-statement-based aggregate accruals ratio is given by:

$$\text{Cash-flow-statement-based aggregate accruals ratio}=\frac{\text{NI-CFO-CFI}}{\frac{\text{NOA}_{t}+\text{NOA}_{t-1}}{2}}$$

#### Example: Computing the Accruals Ratio

Philips Inc.’s selected income statement, balance sheet, and statement of cash flow data, is as shown in the following table:

$$\textbf{Philips Inc.’s Selected Data – Amounts in US\ Thousands}$$

$$\small{\begin{array}{l|r|r|r} \textbf{Selected Income Statement Data} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Net sales} & 164,613 & 149,178 & 135,513\\ \hline\text{Income from continuing operations before tax} & 25,435 & 23,511 & 21,112\\ \hline\text{Income (loss) from discontinued operations} & 244 & (1,869) & 640\\ \hline\text{Net income} & 21,644 & 17,526 & 17,975\\ \hline\textbf{Selected Balance Sheet Data} & & & {}\\ \hline\text{Cash and cash equivalents} & 15,497 & 10,047 & 13,374\\ \hline\text{Short-term securities} & 50,270 & 44,592 & 59,367\\ \hline\text{Total current assets} & 92,344 & 81,186 & 97,974\\ \hline\text{Total assets} & 707,015 & 683,097 & 760,283\\ \hline\text{Short-term debt} & 191,705 & 177,708 & 176,747\\ \hline\text{Total current liabilities} & 259,618 & 244,074 & 239,151\\ \hline\text{Long-term debt} & 339,012 & 290,489 & 286,079\\ \hline\text{Total liabilities} & 733,763 & 712,332 & 783,499\\ \hline\textbf{Selected Statement of Cash Flows Data} & & &{}\\ \hline\text{Net cash from operating activities} & 31,868 & 38,913 & 37,715\\ \hline\text{Net cash from operating activities (continuing operations)} & 34,241 & 33,886 & 32,094\\ \hline\text{Net cash from investing activities} & (50,180) & (33,877) & (37,201)\\ \hline\text{Net cash from investing activities (continuing operations)} & (49,797) & (28,144) & (29,550)\\ \hline\text{Net cash from financing activities} & 24,452 & (4,897) & 5,816\\ \end{array}}$$

Using the above information to address the following questions:

1. Calculate the net operating assets (NOA) for each of the three years for Philips.
2. Calculate the aggregate accruals using both the balance sheet and cash flow statement approaches for Philips for each year.
3. Calculate the balance-sheet-based and cash-flow-based accruals ratio for Philips for each year.
4. Identify any trends in the earnings quality for the company.
5. If the accruals ratio were calculated based only on the continuing operations, how would the results in question 4 be affected?
6. Philips reported net financing receivables of $304,229 in 2019 and$263,436 in 2018. It describes these receivables in the notes to the financial statements as significantly relating to direct financing leases. Examine this disclosure concerning the company’s earnings quality.

#### Solutions

1. Calculate the net operating assets (NOA) for each of the three years for Philips.

##### Solution to Question 1

\begin{align} \text{Net operating assets} & = \text{Operating assets – Operating liabilities} \\ & = \text{(Total assets – Cash and cash equivalents) – (Total liabilities – Short and long-term debt)} \end{align}

These values are in the following table.

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Operating assets} & 641,248 & 628,458 & 687,542\\ \hline\text{Operating liabilities} & 203,046 & 244,135 & 320,673\\ \hline\text{Net operating assets (NOA)} & 438,202 & 384,323 & 366,869\\ \end{array}}$$

2. Calculate the aggregate accruals using both the balance sheet and cash flow statement approaches for Philips for each year.

##### Solution to Question 2

Balance sheet aggregate accruals are defined as the change in net operating assets. Following that, only two years’ worth of accruals can be calculated from the data given. For example, balance sheet aggregate for 2019 equal $$438,202 – 384,323 = 53,879$$.

On the other hand, cash flow aggregate accruals are defined as

$$\text{Net income – (Cash flows generated from operating activities + Cash flows generated investing activities)}$$

For example, cash flow statement aggregate accruals for 2019 are equal to $$21,644 – (31,868 – 50,180) = 39,956$$. The table below represents the rest of the results.

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Balance-sheet aggregate accruals} & 53,879 & 17,454 & -\\ \hline\text{Cash flow aggregate accruals} & 39,956 & 12,490 & 17,461\\ \end{array}}$$

3. Calculate the balance-sheet-based and cash-flow-based accruals ratio for Philips for each year.

##### Solution to Question 3

The accruals ratio is the proportion of the aggregate accruals to average net operating assets. We can only calculate two years of accruals ratio since the denominator requires an average of two years’ data. For example, Philips’s average net operating assets for 2019 were $$\frac{438,202+384,323}{2}=411,262.5$$. Aggregate accruals for 2019 are $53,879 and$39,956 by balance sheet and cash flow statement methods, respectively. Thus, the accrual ratios are $$\frac{\53,879}{\411,262.5}=13.1\%$$ and $$\frac{\39,956}{\411,262.5}=9.7\%$$.

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Balance-sheet-based aggregate accruals ratio} & 13.1\% & 4.6\% & – \\ \hline\text{Cash-flow-based aggregate accruals ratio} & 9.7\% & 3.3\% & -\\ \end{array}}$$

4. Identify any trends in the earnings quality for the company.

##### Solution to Question 4

Using either the balance sheet approach or the cash flow statement approach, Philips has deteriorating earnings quality. Recall that a low accruals ratio implies high earnings quality.

5. If the accruals ratio were calculated based only on the continuing operations, how would the results in question 4 be affected?

##### Solution to Question 5

We subtract the results of discontinued operations from net income and use the cash flow data from continuing operations. We obtain the following results:

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline{\text{Cash-flow-based aggregate accruals-}\\ \text{Continuing operations}} & 36,955 & 13,652 & 14,790\\ \hline{\text{Cash-flow-based aggregate accrual ratio-}\\ \text{ continuing operations}} & 9.0\% & 3.6\% & 0.0\%\\ \end{array}}$$

Using continuing operations does not significantly distort either the level or trends in the accruals of Philips.

6. Philips reported net financing receivables of $304,229 in 2019 and$263,436 in 2018. It describes these receivables in the notes to the financial statements as significantly relating to direct financing leases. Examine this disclosure concerning the company’s earnings quality.

##### Solution to Question 6

The $40,793 change in the accounts receivable accounts for a considerable chunk of Philips’s$53,879 change in net operating assets. In comparison to treating the leases as operating leases, accounting for leases as direct financing leases increases net income during the early years of a lease. However, the same total net income is recognized over the lease life. Under direct finance lease accounting, operating cash flows are lower relative to investing cash flows. When considering the cash versus accrual portions of earnings, this disclosure aids us in concluding that the company’s 2019 earnings are of lower quality than its 2018 earnings.

Both accruals ratios are ideally equivalent as they both measure the degree of accruals present in a firm’s earnings. However, their results can differ because of acquisitions and divestitures, exchange rate fluctuations, and inconsistent treatment of specific items on the balance sheet and the cash flow statement.

## Cash Flow Relationship

To evaluate the representativeness of a company’s earnings, we can compare the cash generated by operations with the operating profit. Here, we seek to address the concern of whether the operating income is confirmed by cash flow. This is done by eliminating cash paid for interest and taxes from operating cash flow by adding them back. The adjusted figure is the cash generated from operations (CGO).

$$\text{CGO = EBIT + Non-cash charges – Increase in working capital}$$

Note: Making the cash interest and tax adjustment to operating cash flow requires care. Firms that follow IFRS have the choice of reporting cash paid for interest as an operating cash flow or as a financing cash flow. If a firm reports the interest as a financing cash flow, no interest adjustment is necessary.

The ratio of cash generated from operations to operating income for Philips is calculated as in the table below:

$$\textbf{Cash Flow to Operating Income}$$

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Operating cash flow (OCF)} & 31,868 & 38,913 & 37,715\\ \hline\text{Cash interest paid} & 1,580 & 1,430 & 1,328\\ \hline\text{Cash taxes paid} & 4,740 & 4,290 & 3,984\\ \hline\textbf{Cash generated from operations} & \textbf{38,188} & \textbf{44,633} & \textbf{43,027}\\ \hline\text{Operating income} & 25,679 & 21,642 & 21,752\\ \hline\textbf{Cash generated from operations/operating income} & \textbf{1.49} & \textbf{2.06} & \textbf{1.98}\\ \end{array}}$$

From the information above, the proportion of cash generated from operations to operating income proves that cash generated from operations is higher than the operating income over the period. These results reduce our earlier concerns about potential earnings manipulation from Philips’s weak earnings quality.

Assume that Philips has recently acquired a 25% equity interest in one of its suppliers, Indo Corporation, which is Canada-based. To evaluate this acquisition, we assess the cash return on total assets.

$$\textbf{Cash Return on Total Assets}$$

$$\small{\begin{array}{l|r|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017} & \textbf{2016}\\ \hline\text{Total assets} & 707,015 & 683,097 & 760,283 & 720,496\\ \hline\text{Cash generated from operations} & 12,109 & 10,560 & 9,228 & -\\ \hline\text{Average total assets} & 695,056 & 721,690 & 740,390 & -\\ \hline\text{CGO/Average total assets} & 1.7\% & 1.5\% & 1.2\% & -\\ \end{array}}$$

We can see that the proportion of CGO to Average total assets, i.e., the cash return on total assets, has increased over the three years. However, the accrual analysis indicated less persistent earnings, which implies potential earnings manipulation. What follows is calculating cash flow to reinvestment, cash flow to total debt, and cash flow to interest coverage ratios.

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousands} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\textbf{Cash Flow to Reinvestment} & & &{} \\ \hline\text{Cash generated from operation (CGO)} & 38,188 & 44,633 & 43,027\\ \hline\text{Capital expenditures} & 10,387 & 9,840 & 9,430\\ \hline\textbf{CGO/Capital expenditures} & \textbf{3.7} & \textbf{4.5} & \textbf{4.6}\\ \hline\textbf{Cash Flow to Total Debt} & & &{}\\ \hline\text{Cash generated from operation (CGO)} & \text{38,188} & \text{44,633} & \text{43,027}\\ \hline\text{Total debt} & \text{530,717} & \text{468,197} & \text{462,826}\\ \hline\textbf{CGO/Total debt} & \textbf{7.2%} & \textbf{9.5%} & \textbf{9.3%}\\ \hline\textbf{Cash Flow Interest Coverage} & & & {}\\ \hline\text{Cash generated from operation (CGO)} & 38,188 & 44,633 & 43,027\\ \hline\text{Cash interest paid} & 1,580 & 1,430 & 1,328\\ \hline\textbf{CGO/Cash interest} & \textbf{24.2} & \textbf{31.2} & \textbf{32.4}\\ \end{array}}$$

The cash flow to reinvestment decreased over the period. However, cash flow was enough to cover capital expenditures by 3.7 times in 2018. This implies that Philips’s cash flows are adequate to cover its ongoing spending. Similarly, the cash flow interest coverage has been decreasing over the period. Nonetheless, the cash flows still covered 24.2 times of interest paid, which indicates more than adequate financial strength in the current year.

In contrast, Philips’s cash flow to total debt of 7.2% implies very high leverage. Philips has financed the majority of its assets with debt. The high leverage has significantly diminished the return on equity and profitability. As such, the company may not qualify for additional borrowing arrangements should an investment opportunity arise.

## Decomposition and Analysis of the Company’s Valuation

So far, we have analyzed companies’ sources of earnings and returns on shareholders’ equity, capital structure, the results of their capital allocation decisions, and the earnings quality. However, before we finalize on financial analysis, we need to also have a look at market valuation.

We mentioned that Philips has recently acquired a 25% equity interest in one of its suppliers, Indo Corporation. Indo Corporation is accounted for in the financial statements as an investment in associates. This is because Philips’s ownership position does not give it control. Indo contributes to the earnings of Philips as a whole, but it is also valued separately in the public markets. However, its discrete valuations may be very different from its embedded Philips’ appraisal. Since our focus is on evaluating Philips’ operations solely, we do this by first eliminating the value of the Indo Corporation’s equity interest from Philips’ market value.

Let’s suppose that the market capitalization of Philips is $200 million. Also, assume that the market capitalization of Indo Corporation is CA$100 million. The USD/CAD exchange rate is US$1.33 at the end of the year. Philips’s pro-rata share of Indo’s market value is$33.3 million (CA$100 million × 25% ×$1.33). Therefore, the implied value of Philips, excluding Indo, is $166.7 million ($200 million – $33.3 million) or 83.3% of Philips’s market capitalization ($166.7 million/$200 million). Let’s now calculate Philips’s P/E multiple, excluding Indo. Let’s suppose Philips’s P/E multiple is 9.2 ($200 million market capitalization / $21.6 million net income). Assuming the S&P 500 multiple is 18.2, Philips’s P/E is a 49% discount to the P/E of the S&P index. The implied P/E multiple of Philips. Without Indo is 8.0 [$166.7 million implied value / ($21.6 million Philips net income –$600 thousand equity income from Indo)]. Thus, Philips’s suggested P/E multiple is an even higher 56% discount to the S&P multiple.

The discount is excessive, given Philips’s strong cash flow position and high leverage. We conclude that Philips appears to be understated based on its implied P/E multiple compared to that of the S&P index. This result is seen after removing Philips’s pro-rata share of Indo Corporation’s market value.

## Summary of Findings for Philips

The operating cash flows have repeatedly exceeded the operating earnings. The ratio of operating cash to operating income has been consistently favorable, providing reassurance in the quality of the earnings.

Measures comparing cash flow with reinvestment, and interest coverage indicate strength in the company’s financial capacity.

Philips’s growth is attributed to the acquisitions. Additionally, Philips appears to be understated based on its implied P/E multiple compared to that of the S&P index. This result is seen after removing Philips’s pro-rata share of Indo Corporation’s market value.

### Concerns

Increasing accrual ratios have revealed potential earnings manipulation. However, this concern diminishes due to Philips’s steady cash flow.

The company may not qualify for additional borrowing arrangements should an investment opportunity arise because of its high leverage. High leverage significantly reduces the return on equity and profitability.

## Question

Earnings quality data for Pride Corporation is as in the following table:

$$\small{\begin{array}{l|r|r|r} \textbf{Amount in US\ Thousand} & \textbf{2019} & \textbf{2018} & \textbf{2017}\\ \hline\text{Net income including taxes} & 4,627 & 3,934 & 3,165\\ \hline\text{Net cash from operating activities} & 10,411 & 5,592 & 3,787\\ \hline\text{Net cash from investing activities} & (9,479) & (3,726) & (4,463)\\ \hline\text{Net cash from financing activities including interest} & (5,203) & 2,129 & (1,652)\\ \hline\text{Average net operating assets} & 43,781 & 45,962 & 41,010\\ \hline\text{Cash paid for taxes} & (1,429) & (690) & (592)\\ \hline\text{Cash paid for interest} & (668) & (95) & 60\\ \end{array}}$$

Pride Corporation’s income statement shows that its EBIT is \$7,309. Additionally, the company follows IFRS reporting standards.

The ratio of operating cash flow before interest and taxes to operating income for Pride for 2019 is closest to:

A. 1.6.

B. 1.7.

C. 1.8.

#### Solution

Net cash flow from operating activity needs to be adjusted for interest and taxes, to be comparable to operating income (EBIT). Pride Enterprise, reporting under IFRS, has classified the interest expense as a financing cash flow; hence, the only necessary adjustment is for taxes. The operating cash flow before interest and taxes is 10,411 + 1,429 = 11,840. Dividing this by the EBIT of 7,309 gives 1.6.

Reading 16: Integration of Financial Statement Analysis Techniques

LOS 16 (e) Analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement-related modifications affect companies’ financial statements, financial ratios, and overall financial condition.

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