Quality of earnings

This post is in continuation to my previous post of analysis of the annual reports and what red flags should a potential investor should look at.

1. What constitutes revenue? What is the share of other income in the revenue? Is the company inflating the sales figure by adding the Sales Tax/VAT/Subsidies?

2. How frequently does it change its accounting policy? (revenue recognition, inventory, depreciation etc.)

3. What is the ratio of cash flow from operations to the overall profit/cashflow?

4. How high is the minority share of profits it is reporting (A lot of holding companies generate a substantial profit from its subsidiaries)

5. If the company is in commodities, does the rise in profit because of capacity expansion or because of rise in the market price of steel?

6. How much volatility in the prices/volume can the company bear?

7. How sustainable do you think is the growth of revenues of the company. What is the capacity utilization? What are the Greenfield/brownfield projects that are due completion

8. What is the share of top 5/10 customers to the overall profit. If a few customers constitutes the entire sale, then the company might have less bargaining power, hence poor quality of revenue.

9. Exceptional items: is the company often reporting charges due to exceptional items? If so then it might be masking a genuine charge as extraordinary expense and giving a false look of high gross margin.

10. What is the ratio of value added and high margin products to the overall sales of the company. Also evaluate if that share is rising or falling.

11. How high is the R&D spend? gives an idea of the sustainability of the company. But if it is too high (unlikely for an Indian firm) then the bulk of the company’s profit might be going into a black hole.

12. How high is the contingent liability… what is its breakup and what is its probability of becoming a real liability.

If there is any more aspects, then please feel free to add.


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