Earnings Quality: Adjusting Accruals For Proper Comparisons
Knowing the total net accruals amount by itself is not very helpful, because this value is not comparable to other firms' total net accruals or with past total net accruals of the same firm; we need something to compare this number to. Total net accruals will be related to the size and the expected growth of the firm. Below, we detail two ways in which to adjust total net accruals in order to put them into a context that will make the analysis more meaningful: scaling accruals and the firm's life cycle.
Before comparing the accrual amounts of one firm over time or with those of other firms, the accrual metric should be scaled by some factor like total assets in order to account for the fact that larger firms will naturally have larger amounts of accruals. You can typically get this job done by dividing the accrual amounts by average total assets.
|Total Net Accruals / [(Total AssetsPeriod 0 + Total AssetsPeriod 1)/2]|
Firm's Life Cycle
In addition to scaling total net accruals for size, the analyst can attempt to classify the firm's life cycle by comparing several operating parameters with those of other firms in its industry. It is generally the case that fast-growing firms will be building up assets (such as accounts receivable, inventory and PP&E) in order to meet current and future demand for its products and/or services. This rapid increase in assets will naturally drive accruals at a higher rate than in a company with declining growth. As a matter of fact, in a declining-growth company, total net accruals should be falling, as this firm's operating cycle will bring in more cash from previously booked sales than it will generate in accruals from current or expected sales. (For more insight, read The Stages Of Industry Growth.)
To begin, a life-cycle metric can be created by observing several operating accounts that are associated with growth, such as sales and cost of goods sold. After scaling for size, which is done by dividing the amounts of each of the following accounting items by the average total assets, high-growth firms will typically experience larger (and positive) changes in sales, higher capital expenditures, higher cost of goods sold, lower cash flow from operations (but higher cash flow from financing) and have fewer years in existence.
The accounting variables for each firm would be similar to the following:
- ΔSales / Average Total Assets
- Capital Expenditure + R&D Expense / Average Total Assets
- Cost of Goods Sold Expense / Average Total Assets
- Cash Flow from Financing / Total Average Assets - Cash Flow from Operations / Total Average Assets
- Firm Age * (-1)
The Life-Cycle Score
The classification of companies begins by gathering firms into groups that are in the same industry. Once firms are grouped according to industry, a variable we will call the life-cycle score is calculated. The life-cycle score can be derived in several ways. A simple way to calculate this metric is to take, for each firm, the specific variables and rank the firms from lowest to highest so that high-growth firms will have bigger values. For example, assume you have five firms in an industry. The firm with the biggest increase in ΔSales / Average Total Assets would rank fifth. Rank each variable and then average the firm's rankings across all five of the variables listed above to arrive at the firm's life-cycle score. (For more on industry classification, read The Industry Handbook.)
If desired, the life-cycle score can then be described by creating five bins based on the range of the life-cycle score and the number of firms in the group, and assigning each firm to a bin:
- Late Decline
- Early Decline
- Mature Growth
- Moderate Growth
- High Growth
|Company A||Company B||Company C||Company D||Company E|
|ΔSales / Average Total Assets||5||3||1||2||4|
|Capital Expenditure + R&D Expense / Average Total Assets||
|Cost of Goods Sold Expense / Average Total Assets||4||2||1||3||5|
|CF from Fin /
|Firm Age * (-1)||5||4||2||1||3|
|Life Cycle Score (Average of Individual Ranks)||4.6||3||1.6||1.6||4.2|
|Score Description||High Growth||Mature Growth||Late Decline||Late Decline||Moderate Growth|
|Figure 11: The Life-Cycle Score Calculation|
The information resulting from the life-cycle classification can be used as a tool in quantitative models or just be kept in mind as the analyst interprets the results of any accrual or non-accrual analysis. Either way, the end result is to bring another dimension of understanding to firms with extreme accrual amounts. For example, the conclusion that high accruals indicate poor earnings quality would be weakened if the firm was a high-growth firm but strengthened if the firm was in the late-decline category. On the other hand, high-growth firms typically do not generate enough cash flow to internally finance their high growth and will tend to access the financial markets more often than slower growers. Remember, the need to secure outside financing is an incentive to manage earnings. Thus, interpretation of the life-cycle score regarding total net accrual amounts requires context gathered from the non-accrual review as well.
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