Hi all, Which one reflects a higher earning quality, -1% or -5%? I will answer -1%, because the difference between cash earning and accounting earning is smaller, which means more sustainable and persistent in the future? What is your understanding?
If the earnigns quality based on the accurals ratio is negative that is better than a positive. The reason this is the case is becasue in order for the accurals ratio to be negative from the B/S equation it means that you have negative net operating assets (which will rarely happen). If you have negative net operating assets it means you have a high level of accured liabilities that are intended to reverse in the coming year (meaning better earnings quality the next year).
The imprtant thing however, is normally to look at trend. If your accurals ratio is higher than another firm but is moving lower this then the trend is your friend.
a -5% would be better than a -1% from my understanding.
Thanks
I would assume a “smaller accrual ratio” to mean closer to a zero
Quality of earnings assumes sustainablitiy of earnings.
For a simple example,
If you have higher level of payables than receivables, it will generate negative accrual ratio.
Higher level of payable are not sustainable. Your suppliers may tighten the credit sales and you may have to reduce payables.
Same applies to positive ratio… your receivables are higher… which means you have less cash on hands… so you may have to raise from somewhere else. which is not sustainable.
Accrual ratio close to zero is sustainable.
yes. I also assume lower the absolute value of accruals, higher the earning quality.
-5% is lower than -1%
But lower isn’t always equivalent to _ smaller _.
Closer to zero is best. Just play with some numbers.
If you compare EBIT with CFO-CFI, you get a negative ratio when your cash inflows are larger than your accounting profit.
How is this possible? May reasons for example monetization for your working capital but consider how sustainable it is for a company to receive cash that it isnt earning.
If I see a company with a strongly negative accruals ratio I think, 1) shame i didn’t own the company when it paid out this additional cash) and 2) This level of FCF yield is probably unnaturally high, I would therefore adjust DOWN my estimates of future free cash
TLDR; close to 0 is best long term