Quick question.
They give us two methods for calculating accruals ratio to measure earnings quality.
Whys is it that under the CF approach, the formula is: NI - CFO - CFI?
Id have guessed wed only measure the difference between NI and CFO to get the accruals relative to operations, right? Why is CFI in the calculation at all? Can someone clarify that?
Thanks!
Anyone?
I will answer your question in a roundabout way - with a story.
I grew up in South Florida (lots of Brazilians) and on my last visit I met up with an old friend from high school who owns and operates gay bars. His background is restaurant operations, not finance. Some friends of his asked him to invest in a new bar in a different city that he would primarily only be involved in as an investor. He helped them get started. He told me that he followed the bar’s finances and performance by simply looking at the bank statement each month. The balance was going up each month, so he felt the bar was doing well. He never looked at Financial Statements.
In there is your answer.
NI-CFO-CFI is essentially comparing the change in bank balance against accounting profit (excluding financing transactions). It doesn’t necessarily answer questions, but may lead you to ask more. For example: If I am making profits, why isn’t my bank balance going up? It could be accruals (AR is increasing), or it could be an increase in some asset like a building you acquired with cash. Or converesly, if Cash is going up, but NI isn’t, maybe you borrowed some cash. Or stopped paying vendors. It is something you would probably want to understand.
Nice answer. Thanks for that!