Earnings: Watch for These Red Flags

Here are some metrics that investors should look for when trying to assess the quality of companies' financials

Just how well—or badly—are companies doing amid the current downturn? Most outfits have gotten quite adept at making their quarterly financial numbers look as attractive as possible. One way to gauge the relative safety of stocks is to distinguish companies whose earnings are more likely to be sustainable over time from those whose profits may prove short-lived. With first-quarter earnings season beginning in earnest, BusinessWeek decided to take a look at some metrics that investors should watch carefully when trying to assess the quality of companies' financials.

With the U.S. economy on the skids and global trade suffering, expectations for first-quarter earnings understandably are quite low. As of Apr. 3, total earnings for the companies that make up the Standard & Poor's 500-stock index were expected to be down 36.6% in the first quarter from a year earlier, according to the Thomson Reuters Proprietary Research Group. For the first time in the 11 years that Thomson Reuters (TRI) has been tracking sector growth rates, all 10 sectors are expected to show a year-over-year decline in profits.

For investors patient enough to look beyond the headline numbers, including net income per share and revenues, and what companies are including and excluding in results based on accounting moves, earnings reports can provide a wealth of clues about how good a bet a stock may be in the long run. Even better, of the three statements that make up a quarterly financial report, by far the least susceptible to accounting manipulation is the cash-flow statement. Ronald A. Kiima, former assistant chief accountant in the U.S. Securities & Exchange Commission's Corporation Finance Div., tells his clients to focus on cash flow if they want to see how strong a company's financial position is.

Lots of Cloud Cover

The vast majority of public companies engage in some form of questionable earnings management, at least on the margin, according to Kiima, who now heads a consulting firm that specializes in SEC accounting and disclosure issues and corporate governance and risk management.

While companies have long tweaked accounting rules to make their results look better, largely through legal means, such maneuvers "give people a lot of cloud cover and latitude to play around on the margin, at least," he says.

Historically, the most common cause by far for companies having to restate their financials or submit to other SEC enforcement actions has been the way in which they have recognized revenue. That's because the higher up in the income statement the numbers are massaged, the larger the effect on a company's bottom line, says Kiima. And within revenue recognition, the most prevalent form is premature recognition, or booking sales before prices have been fixed, contracts have been finalized, or goods or services have been delivered to customers.

Revenue recognition aside, the biggest single issue right now, in view of the economic distress, is asset impairment, which isn't unique to financial institutions, for all the public attention that's been trained on them, he says. "As an investor when I look at a [company's] financial statement, it's kind of guilty until proven innocent," he says. "In this kind of distressed economy, I would start off expecting to see impairments and then I would need to be convinced there's good reason why a company has not booked an impairment."

Watch Companies Making Acquisitions

At minimum, he says he would look for mention in a footnote of an impairment test that had made the company decide it can still recover the full book value of the assets over time.

Companies that have been very active in acquiring assets from other companies are prime candidates for asset impairment, in Kiima's view. Acquirers get to book as intangible assets values for customer relationships, trademarks, and a target company's market dominance. In a distressed economy such as the current one, it often comes to light that the acquirer may have overpaid for assets.

Monitor Credit Quality

It's not only long-term assets but short-term ones such as accounts receivable that bear watching. A noticeable rise above trend in either receivables or days sales outstanding—the average period of time it takes customers to pay for goods or services—could be a sign that a company is inappropriately extending credit to its customers, says Jeremy Payne, senior vice-president at CapitalIQ. (Like BusinessWeek, CapitalIQ is a division of The McGraw-Hill Companies (MHP).)

An increase in receivables or days sales outstanding is a concern only if you think customers won't pay their bills, he adds. If you could prove that a company was booking sales that it had little or no reason to expect to be paid for, it could qualify as a violation of securities law, he says.

There are 157 companies with market caps above $100 million trading on a major U.S. exchange whose receivables for the last reported quarter are the highest or second-highest they have been in the last five years, according to data run by CapitalIQ. These companies are also in the bottom 20% of their primary industry for the last 12 months in terms of revenue growth.

Inventory Issues Require Vigilance

Plummeting demand for semiconductor chips in the closing months of 2008 made manufacturers see how overvalued their inventories were and forced them to take large writedowns in the fourth quarter. For example, in January, Nvidia (NVDA), the maker of graphics computing chips, took an inventory charge of about $50 million for the fourth quarter of fiscal year 2009, roughly 5 to 10 times higher than the level of inventory reserves it had recorded during the first three quarters of that fiscal year.

But such a painful writedown could actually make future results look better. When demand returns, these companies will start to ship that inventory, which will result in an artificial bump in gross margins, says Patrick Wang, an analyst at Wedbush Morgan who covers the semiconductor industry. There's scant risk that technology advances will make old inventory obsolete, since consumers in emerging markets who are buying their first computer or television "don't need the fastest, latest, or greatest," he says.

While semiconductor stocks have rallied 30% to 50% since January, when distributors began to order again to restock their inventories, Wang believes more experienced investors have been partially discounting any gross margin benefits and focusing on less easily massaged metrics like cash flow.

Slashing Accounts Receivable

Where the deepening recession has caused significant increases in receivables for companies across a wide range of industries, many semiconductor makers have been aggressively reducing their receivables to make their cash-flow statements more enticing, says Wang.

Monolithic Power Systems (MPWR) slashed its accounts receivable by more than 50% between the third and fourth quarters, from $18.8 million to $9.1 million, and its days sales outstanding fell from 35 to 24, though a large part of that was because new orders from distributors dried up.

Nvidia reduced its receivables from $608 million to $318 million between the third and fourth quarters and pushed its days sales outstanding from 62 to 60. "The best way to combat low revenues and net losses is to [massage your cash flows] by collecting as much as you can from customers and to negotiate with suppliers to push out your accounts payable as much as possible," he says. In the meantime, reducing their head count and making temporary salary cuts help companies to lower their working capital needs, he adds.

Keep an Eye on Deferred Tax Assets

Semiconductor companies benefit by being more exposed to the early stages of an economic cycle than finished goods manufacturers. Plus, their top managers have been in place for three or four cycles and are able to recognize early signs of a downturn, says Wang.

Deferred tax assets are another area of concern to accounting consultant Kiima. Many companies have booked as assets net operating losses that they are carrying forward on their balance sheets from the years before they turned a profit. Greatly diminished taxable earnings and the prospect of low or no profits for years to come mean that a company may not get to use these tax credits before their statutory life expires. Financial Accounting Standards Board rules require companies to write down the value of those credits to the valuation level they think is more likely to be used in the future. That will eventually boost the company's income tax liability and reduce its earnings.

If you see deferred tax assets, Kiima advises you to check the footnotes to see what they are made up of and if there's a tax credit, whether it's likely to be used before the net operating loss carry-forward expires.

Watch for Incongruities

It's very unlikely that a company's missteps will jump out at you, accounting experts say. More often, it's a matter of noticing incongruities between various parts of a quarterly filing.

If there's a dramatic increase in the assets on a company's balance sheet but you notice on the cash-flow statement that depreciation isn't rising at the same pace, that could be a red flag, says Bruce McCain, chief investment strategist at Key Private Bank (KEY) in Cleveland. "There should be some sort of reasonable relationship [between asset values and depreciation] if it's a normal business operation," he says.

Increasing depreciation might indicate a company is capitalizing costs over an extended period of time that should have been expensed in one quarter. Doing that can inflate its earnings.

Kiima likens a financial statement to a circuit breaker, which is more likely to trip the more pressure is put on it. "That's the times we're in right now," he says.

Auditors Are First Defense

It's easier to have faith in companies' ethics when times are good since there's little reason to fiddle with accounting when everyone's fat and happy, he says. But when top managers are under duress, they're "more inclined to take some liberties and round some corners off," he says.

Investors and analysts need to stay alert and anticipate events. For example, even if a company reports that its sales are strong enough for it to have avoided having to write down the value of assets so far, a sharp downtrend in cash flow that's expected to continue means it's only a matter of time before the company runs out of wiggle room and has to start taking charges for impaired assets, he says.

The first line of defense is the company's auditors, who can refuse to sign off on financial statements if they find that companies are playing around with accounting rules. "We can only hope they have a backbone," says Kiima.

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