Learning Outcomes
After studying this article, you will be able to evaluate the quality and sustainability of company earnings, distinguish between accrual and cash earnings components, and assess cash flow modeling methods as required for industry and company analysis. You will also learn to interpret red flags for low-quality reporting, identify earnings management tactics, and analyze how cash flow data informs valuation and risk assessment for the CFA Level 2 exam.
CFA Level 2 Syllabus
For CFA Level 2, you are required to understand and apply concepts related to earnings quality and cash flow modeling when analyzing industries and companies. In your revision, focus on the following:
- Assessing indicators of earnings quality and the persistence of reported profits
- Identifying earnings management techniques and low-quality reporting risks
- Evaluating accruals and distinguishing between cash and noncash earnings
- Modeling cash flows and interpreting their impact on valuation
- Recognizing the implications of accounting choices on earnings and reported cash flow
- Detecting red flags for aggressive or misleading financial reporting
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which component of net income is typically less persistent and more prone to estimation error: cash flows or accruals?
- What are two common warning signs that a company may be managing earnings?
- How does capitalizing operating expenses affect reported earnings quality?
- Why is operating cash flow a key metric when evaluating the sustainability of reported profits?
Introduction
Earnings quality and cash flow modeling are central to industry and company analysis for the CFA exam. High-quality earnings reflect a company's true economic performance and are more likely to persist into future periods. Analysts must judge whether reported profits can be trusted, whether they are sustainable, and whether they faithfully represent the company's financial condition. This article explains how to evaluate earnings quality, interpret accruals and cash flows, and identify risks of misleading reporting or earnings management.
Key Term: earnings quality
The degree to which reported profits reflect a company's actual economic performance and are likely to persist in future periods.
INDICATORS OF EARNINGS QUALITY
Persistent vs. Transitory Earnings
High-quality earnings are those that are both adequate (cover the company's cost of capital) and persistent (expected to recur). Transitory or one-off items lower earnings quality.
Key Term: persistence
The tendency for profits or losses to continue in future periods.
Accruals and Cash Flows
Reported net income includes both cash and accrual components. Accruals arise when revenues or expenses are recognized before cash is received or paid. The accrual component of earnings is generally less persistent and more easily manipulated than the cash component.
Key Term: accruals
Noncash adjustments to net income due to recognition of revenues and expenses before or after associated cash flows.Key Term: operating cash flow (OCF)
The cash generated from a company's core business activities, usually reported on the statement of cash flows.
When earnings are mostly cash-based, they are considered higher quality. Unusually large accruals, or an increasing gap between net income and operating cash flow, are warning signs.
Earnings Management and Aggressive Reporting
Companies may use various tactics to inflate reported earnings, including:
- Recognizing revenue prematurely
- Deferring expenses by capitalizing costs
- Classifying recurring items as “nonrecurring” or “special”
- Manipulating reserves or allowances
Key Term: earnings management
The deliberate use of accounting choices or estimates to influence reported profits or meet analyst expectations.
Excessively smooth or consistently beating consensus earnings forecasts is another red flag. Companies may shift income across periods through accrual or classification manipulation.
Common Red Flags for Low Earnings Quality
- Rapid accrual growth outpacing revenue growth
- Consistent divergence between profit and operating cash flow
- Frequent changes in accounting policies or estimates
- Rising days' sales outstanding or decreasing asset turnover
- Significant one-off gains boosting profit
EVALUATING CASH FLOW MODELING
Reliable cash flow modeling is critical to understanding a company's value and risk profile. Cash flows can be modeled at different levels:
- Operating cash flow: Indicates if profits are supported by actual cash generation.
- Free cash flow: Assesses debt service capacity and the company's ability to invest or pay dividends.
- Discretionary cash flow: Evaluates resources available after capital expenditures and mandatory obligations.
Key Term: free cash flow (FCF)
Cash available to stakeholders after accounting for operational needs and capital investments.
Interpreting Accruals Ratios
The accruals ratio quantifies the proportion of net income not supported by cash flow, calculated as:
Accruals ratio = (Net income − Operating cash flow) / Average total assets
A high or rising accruals ratio signals low earnings quality.
The Role of Accounting Choices
Management's flexibility in accounting—such as depreciation methods, inventory valuation, or lease capitalization—can significantly affect earnings quality and cash flow. Analysts must adjust for aggressive policies to avoid overestimating sustainable profitability.
Worked Example 1.1
A company reports net income of $100 million, but its operating cash flow is only $60 million. Total assets average $500 million. Calculate the accruals ratio and comment on earnings quality.
Answer:
Accruals ratio = (100 − 60) / 500 = 0.08 (or 8%).A high accruals ratio (typically above 5–10%) may indicate low earnings quality, as a significant proportion of profit is not converted into cash.
Worked Example 1.2
XYZ Ltd. capitalizes $20 million of software development costs as an intangible asset. If these costs would otherwise be expensed, what is the immediate effect on earnings quality?
Answer:
Capitalizing operating costs increases reported net income (and assets) in the current period but reduces earnings quality. The adjustment defers recognition of real expenses, making profits less sustainable.
Exam Warning
Earnings management often involves “cookie jar” reserves—overstating expenses or provisions in good years and releasing them in weak periods. Beware of reversals in allowances or reserves that boost profit in later periods.
USING CASH FLOW ANALYSIS IN COMPANY VALUATION
Analysts rely on cash flow modeling for:
- Discounted cash flow valuation (e.g., DCF, FCFE, or FCFF models)
- Assessing dividend sustainability
- Measuring financial health and default risk
Forecasts should adjust historical cash flows for nonrecurring items and normalize for economic conditions.
Worked Example 1.3
Alpha Corp. reports net income of $50 million, with $10 million in nonrecurring restructuring gains included. Calculate adjusted net income and explain how this affects your cash flow model.
Answer:
Adjusted net income = $50 million − $10 million = $40 million.For valuation modeling, the initial cash flow input should reflect only sustainable (core) earnings. Excluding nonrecurring gains ensures forecasts are not biased upward.
Summary
Earnings quality and cash flow modeling are essential for industry and company analysis in the CFA exam. Analysts must distinguish persistent profits from one-off or manipulated items, understand accrual effects, and recognize how accounting policies shape both reported results and risk. Sustainable cash flow, rooted in genuine operations, is critical for reliable valuation and risk assessment.
Key Point Checklist
This article has covered the following key knowledge points:
- Assessing the persistence and sustainability of company earnings
- Identifying accruals and interpreting accruals ratios as earnings quality signals
- Recognizing earnings management tactics and financial reporting red flags
- Understanding how accounting choices impact both earnings and cash flows
- Modeling and adjusting cash flows for valuation and risk analysis
- Linking cash flow and accrual quality to company valuation and risk
Key Terms and Concepts
- earnings quality
- persistence
- accruals
- operating cash flow (OCF)
- earnings management
- free cash flow (FCF)