Quality of Earnings - Case Study Example

Quality of Earnings Earnings Quality: Definition and Background Earnings quality is the evaluation process of the degree to which a companys earnings are generated from sustainable fonts that are supported by cash flow. The earnings quality has two dimensions: the perseverance and the cash flow dimensions. The persistence dimension tries to identify whether the reported earnings have been boosted by non-recurring items. For example, the earning that have been increased from the sale of the firm assets such as land or a one-time reduction of the taxes rate due to tax lose as a result of tax loss carry forward would prejudice the quality of the incomes. In the evaluation of the cash dimensions, attempt is made to identify and determine whether the reported earnings are supported by the cash flow. For instance, cash flow would holdup incomes for a firm that has provided its clients with prolonged payment agreements or that has accrued inventory in expectation of augmented future sales. Such lagging cash flow would blight earnings quality on the cash dimension. The balance sheet plays a very vital document in assessing the quality of earnings of a firm. The term position quality is commonly referred to the balance sheet when used to calculate the quality of earnings. The position quality is impaired if the assets of the firm are carried at amounts that surpass the fair value or when obligations are carried at amount less than that required to liquidate them (Lewis & Indiana University, Bloomington, 2007). Introduction Quality of earnings analysis is, therefore, an essential characteristic of the assessment process is obtaining a clear comprehension of the targets quality of earnings. An evaluation of the quality and sustainability of incomes should be carried out early. Evaluations enable an earlier encouragement or a dissuasion conclusion and certify that baseline assessment methods are rational and impregnable in the determination of pricing and other deal terms. Comprehending the sustainability of earnings and how that influences on business deal value and forecast modeling is vital to sail across the exceptional features of any deal. The intension of this summary information on discrete companies hence is to enable more emphasis and consideration on one or more dimensions of quality of earnings. For instance, might pinpoint non-recurring additions that thought to have reduced the companys incomes on the persistence approach. Alternatively, lessening cash flow may be the objective, impairing quality of earnings on the cash aspect. Finally, for some firms might look at the balance sheet where the position quality might be impaired due to overrated assets or underestimated liabilities (Lewis & Indiana University, Bloomington, 2007). Business description of Acuity Brands Inc. The company which has a financial year 2011 net sales which were, estimated at $2.5 billion comprised of Acuity Brands Lighting and Acuity Specialty Products. The company is one the worlds largest and leading providers of lighting fittings. It produces a different of brands of lighting fixtures such as Homophone, Lithonia LIGHTING and Antique street lamps. Acuity Specialty Product is largest provider of the unique chemical with a different varieties or brands too, such as Zep Commercial and enforcer. The Cash Flow Shortfall After struggling in the time between 2007 – 2009, Acuity Brands Inc. enjoyed steady incomes for the years that ended in November 30, 2010 and 2011. Net income (from ongoing processes attributable to) was $92.2 million and $95.3 million, correspondingly, for the years ended November 30, 2011, up from losses incurred amounting to $417.1 million, $1,103.1 million and $1,867 million, respectively, for the years 2009, 2008 and 2007. (Lewis & Indiana University, Bloomington, 2007). Net Income (from Current Operations) Functioning cash flow, however, has dropped short of the firm’s incomes enhancement. From the latest high of $1,100.8 million in the year 2008, working cash flow has tumbled each year, eventually turning negative in 2011 at -$259.1 million. This is shown in the graph below (Lewis & Indiana University, Bloomington, 2007). With the decline in operating cash flow comes an accompanying decline in the company’s free cash flow. Free Cash Flow (Lewis & Indiana University, Bloomington, 2007). The detected lag in functional cash flow comparative to net income establishes as a drop in the earnings quality gauge, EQI. EQI determines the quality of earnings on the cash measurement. The metric integrates fluctuations in operating cash flow and net incomes in a single dimension. Earnings Quality Indicator (EQI) (Lewis & Indiana University, Bloomington, 2007). Factors that contributed to the cash flow shortfall According to reports the company, the faced much struggle in the time between 2007- 2009. The company despite enjoyed steady earnings d for the period that ended in 2011.This deficiency of the cash flow can be attributed to a number of factors that include an increase in the inventory. The company in the specified years directed many its resources to investments in land and home. The inventory increased to 512.4 income days from 495 days. Many lands were bought and put under development that increased the business assets. The company also paid taxes of about $ 12.0 million the year 2011 and received a cash refund of $341 million. The income tax receipts and the payment are included in the operating cash flow. By 2011, the company had a net tax deferred asset of $ 577 million. This an asset signifies the tax investments from forthcoming tax deductions in the form of net operating at a loss carry forward as well as functioning expenditures recorded on the fiscal announcements that have not hitherto been subtracted on the corporation’s tax return (Lewis & Indiana University, Bloomington, 2007). Other factors that impacted operating cash flow comprise receivables, which contain all the amounts due from consumers for home sales and mortgages on properties sold. Receivables augmented by $132.3 million in 2011, reducing working cash flow, dropped by $340.4 million in 2010, increasing operational cash flow, and amplified by $117.9 million in 2009, tumbling operating cash flow. An upsurge in other company’s properties abridged operating cash flow by a figure of about $112.5 million in 2011. The effects in previous years were slight. Debility in payables and other charges abridged operating cash flow by $106.8 million in 2011, $120.9 million in 2010 and $95.9 million in 2009. While not impacting reported effective cash flow, the firm does release problems with obligors on the company’s mortgage receivables. The firm unveiled that it acquired $467.7 million and $186.0 million in real estate owned in 2011 and 2010, correspondingly, in the gratification or fractional satisfaction of credits receivable. The transformation of mortgage notes to real estate owned will influence future functioning cash flow through abridged interest (Lewis & Indiana University, Bloomington, 2007). In summation, a number of factors could also have triggered a decline in the cash flow. The states of the economy and management problems are some of them. The most important aspect of any firm assessment analysis is the evaluator’s capability to read, comprehend and deduce a Company’s fiscal statements – an expertise essential to making an accurate and precise valuation of the value of any business. This is because most assessment procedures incorporate modifications to the value based upon proofs revealed during the progression of the assessment process, many of which relate to the Firm’s fiscal statements. In addition, the evaluator is trying to measure the value of the company’s ancient and predictable future earnings, which in most firms is a vital constituent. Analysts and financiers interested Acuity Brands Inc. in will, therefore, want to pay a keen consideration to the cash flow deficits the company is come into contact. To be particular, for the explanations cited, the incomes enhancements the firm has enjoyed not been complemented by developments in operating cash flow, which has now curved negatively (Lewis & Indiana University, Bloomington, 2007). Work Cited Lewis, M. F., & Indiana University, Bloomington. (2007). Assessing earnings quality at the IPO: The role of reputable investment banks. Bloomington, Ind.: Indiana University. Read More