Module 18.3 LOS 18.h: Evaluate the earnings of a company

Earnings recognition can be subjective; therefore, analysts should assess the quality of earnings, not just the value. There are many practices, including legal ones, which could be red flags to poor earnings quality, even if the revenues seem to grow or are in line with expectations.  For example, higher growth rate of receivables relative to the growth rate of revenues is a red flag. Similarly, an increasing days’ sales outstanding (DSO) over time is an indication of poor revenue quality.

Another way to boost reported performance is to under-report an operating expense by capitalizing it. Capitalizing an expense does however show up on the balance sheet as an asset and an analyst should be wary of unsupported changes in major asset categories. When the proportion of PP&E increases over time in common size balance sheets, analysts should question whether there is a systematic capitalization of expenses underway.

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