Page 107 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 19.e: Analyze and interpret how balance sheet modifications, READING 19: INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES
earnings normalization, and cash flow statement related
modifications affect a company’s financial statements, financial
ratios, and overall financial condition. MODULE 19.5: EARNINGS QUALITY AND CASH FLOW ANALYSIS

Earnings Quality and Cash Flow Analysis
We can disaggregate earnings into their cash flow and accruals components using either a balance sheet approach or a cash flow statement approach. The
interpretation of both ratios is the same: the lower the ratio, the higher the earnings quality.

Accruals Ratio
Balance sheet approach: Change in net operating Cash flow statement approach. We can Recall that IFRS allows some
assets over a period. Net operating assets (NOA) is also derive the aggregate accruals by flexibility in the classifications of
the difference between operating assets and subtracting cash flow from operating certain cash flows, primarily interest
operating liabilities: activities (CFO) and cash flow from and dividends paid. Thus, for firms
• Operating assets are equal to total assets minus investing activities (CFI) from reported following U.S. GAAP, it may be
cash, equivalents to cash, and marketable earnings as follows: necessary to reclassify these cash
securities. Operating liabilities are equal to total flows from operating activities to
liabilities minus total debt (both short term and financing activities for comparison
long term). purposes.
Like the balance sheet accrual
measure, the cash flow measure
Just like ROA and ROE, the measure can be must be scaled for comparison
distorted if a firm is growing or contracting purposes. Thus, the accruals ratio
quickly. Scaling the measure allows for based on the cash flow statement is:
comparisons with other firms. Scaling is done by
dividing the accrual measure by the average NOA
for the period. The result is known as the accruals
ratio: