flow from operating activities, have both increased significantly over the 2008-2010 period, why would there be any concern over cash flow sustainability or earnings quality?
- The least accurate reason that Puglisi can give in response to Fong’s criticism is that:
A. growth in net income exceeds growth in revenues.
B. growth in net income exceeds growth in cash flow from operating activities.
C. the ratio of cash from operation before interest and taxes to operating income is decreasing.
_ I didn’t get this answer correct? maybe because i am running on 3 hours of sleep. can someone please explain the logic behind each answer? _
thank you kindly!
my vote go for B. Generally Income growth should backed by cash flow growth.
I must say that this questions is not very well structured.
A: If NI growth is outpacing Revenue growth you might be concerned about sustainability of earnings growth (growth could be ST-oriented changes).
B: IIRC, the focus on CFO toward the end of FRA compares it to Revenue as an indicator for earnings quality, not NI. I did not recall correctly, NI is compared to CFO in relation to reporting quality (likely also earnings quality but I didnt keep reading).
C: CFO before taxes and EBIT are in like-terms and a decreasing cash flow could be a warning sign for funny book keeping to inflate EBIT.
Im going with C but, honestly, I suck at FRA and am half making up the rationales above.
What does the book give as the answer?
Generally all cash flows are after tax basis. In option C: They are saying cash flow before taxes doesn’t make sense to me.
True about C…
I flipped thru the book a little and on pg 323 in FRA it mentions that NI consistently in excess of CFO may indicate manipulation/low quality reporting, but not always (using Enron as an example).
I think youre right with B.
Correct answer is A
Earnings quality is concerned with the level of accruals in net income and whether net income is backed by cash flows. The large difference between the growth in net income (24.8% given in the MD&A) and cash from operations (3.4%) would be an indicator of lower earnings quality and lack of cash flow sustainability. Revenue growth (calculated at 8.06% compound growth from 2008 to 2010) would not be as strong an indicator of lower quality earnings as the poor relationship between net income growth and cash from operations growth. The decrease in the ratio of cash from operations before interest and taxes to operating income also indicates that earnings quality is decreasing.
I missed the " least accurate reason" part.
Hahaha me too - really highlights the importance of sleep ahead of time.
Rasec, there is an emphasis on comparison of income and cash flows for earnings quality. Both metrics in A are in the income statement. They could be cutting costs or otherwise improving profitability through legitimate means.
They are more concerned with NI consistently outpacing CFO, indicating an accrual of accounting gains that are not matched with real cash flow.
Damn Rasec! I was hesitating between B and C! Now i’m relieved hahaha. Dude next time change the font for “least” or “more likely” like they do in the curriculum!