In the early part of this decade we learned, ironically enough, earnings don’t represent real money. When a company says it earned a dollar per share last quarter, it doesn’t always mean it has that dollar to spend on dividends, share repurchases, debt repayment, or re-invest in firm’s operations.
As we all know that a dollar of earnings is comprised of assumed non-cash earnings called “accruals.” These accruals are not bad or negative for a firm, but they can be red flags in identifying a changing operational environment or potential management manipulation. I will give a few red flags that you should be aware of:
Sharp rise in inventories: This may suggest difficulties in generating sales, over costing instead of expensing items, or overproduction; all of which are not good.
Sharp rise in payables: This may imply problems with paying suppliers, which be due to insufficient sales or credit difficulties.
Sharp increase in accounts receivable: This may signal rising competitive pressures forcing the firm to extend better credit terms; this is sacrificing future sales for today. Also, inconsistent percentages representing reserves against receivables can be a sign that management is using these reserves and a “cookie jar” to produce earnings.
Disclaimer: Keep in mind, a rise in inventories may also indicate that a manager feels sales will rise in coming quarters. In many cases inventories, payables, and receivables may be seasonal; therefore, they need to be taken into the context of the firm’s history and industry.
I am not going to make the assertion that all firms with these red flags are the next “Enrons,” but in the last year of Enron’s operations all of these red flags were present. For example, Accounts receivable increased over 300% from 1999-2000. Inventories doubled, and Accounts Payable increased 400%.
There are ways to screen and compare firms with low or negative accruals, which is indicative of a firm generating large amounts of cash. The most common is the Accrual Ratio.
To calculate the accrual ratio, simply subtract FCF from Net Income and divide the result by Total Assets. When FCF is greater than Net Income, the Accrual Ratio is negative, which is good because cash earnings are greater than accounting earnings. When Net Income is greater than FCF, it indicates that part of the income was the result of non-cash items (accruals). Earnings spiked by accruals are considered to be of a lower quality and can be indicative of manager manipulation or a changing operational environment.
I have created a starting point for investment ideas using the following screen:
- Accrual Ratio > .5 (or <.5, depending on long or short)
- Net Income > 0
- Not in the financial sector
- Market Cap > $1 Billion
|Longs||Ticker||LFY Accrual Ratio|
|Shorts||Ticker||LFY Accrual Ratio|
|Baldor Electric Co||BEZ||58%|
Twelve years ago Richard Sloan, from the University of Michigan, made a groundbreaking discovery; shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones. He suggest that investors focus too heavily on earnings and not on cash generation, and this can lead to earning surprises and multiple expansion in the future. For this reason, the Accrual Ratio is a great starting point for any stock screening strategy.