APPENDIX B
QUALITY OF EARNINGS CASES:
A COMPREHENSIVE REVIEW
CASE 1: LIBERTY MANUFACTURING
The analysis that can be done on Liberty is limited because there is no access to macroeconomic
information, industry data, or the company’s financial statements from the past several years. The
following comments are based solely on the information provided and must be viewed as limited for that
reason.
Ratio Analysis at Face Value
Liberty’s reported profits of $159,000 appear to be relatively high. Return on equity is 20 percent
($159,000/$799,000), return on assets is approximately 6.6 percent ($159,000/ $2,399,000), return on sales
is 14.5% ($159,000/$1,100,000). [Note: ratios are calculated without balance sheet averages so that two
years can be analyzed.] The company turns over its inventory, on average, about every 90 days (4 times per
will slow down cash collections and may reduce the company’s solvency position.
The debt/equity (total liabilities/stockholders’ equity) ratio represents another source of concern, because
it indicates that the company is carrying a much higher percentage of liabilities as of the end of the second
year. Specifically, the ratio increased from 1.24 to 2.00. The increase was caused primarily by increases in
company’s earnings power appears to be sufficient to cover the necessary debt payments if receivables are
collected on a timely basis.
Earnings Persistence
can be considered persistent.
Quality of Earnings
The quality of Liberty’s earning number is also questionable. The allowance for uncollectibles account
dropped dramatically as a percentage of outstanding accounts receivable (from 6.7 percent to only 1.8
percent). This drop suggests Liberty’s management is protecting the income statement from bad debt
units, a one-time increase in income is created. The total amount of this increase was $210,000 ([($16–
$12)*10,000] +[ ($16-$6)*10,000] + [($16-$2)*5,000]).
Recommendation
Based on this analysis, I would not recommend that the applicant be considered further for a loan. Its
solvency position is weak, and its reported earnings contain a number of items that are not expected to
CASE 2: MICROLINE CORPORATION
MEMO
To: Sharon Sonneborn
Re: Evaluation of Microline Corporation
Microline is a potential acquisition candidate for Mega Industries. As such, Mega Industries requires an
0.46 to 0.72. The increases in these ratios are due to an increase in current assets rather than a decrease in
current liabilities. One reason for the improvement in the current ratio is that Microline issued a long-term
note that contains a debt covenant requiring a current ratio greater than one. The increases in the
from 0.89 ($20,000/$22,500) to 1.16 ($27,500/$23,750). This means that Microline is financed with slightly
more debt than equity. Based on its reported profits, the interest coverage ratio is strong at 5.75 ($4,750 +
$1,000/$1,000), up from 3.8 ($1,700 + $600/$600). However, since the two new notes equal to $7,000
were issued, the year’s interest expense is not reflective of expected interest expense in the future. If both
notes are at an 8% rate, interest expense will be almost $500 higher in the next year. Without additional
them, Microline would have had $3.75 million less in income and would have, in fact, reported a loss for the
year.
In addition to poor earnings persistence, earnings quality also may be poor for several reasons. First, the
sales on the land and short-term investments appear to have been executed solely for the gains achieved.
Immediately after the sale of the land, similar land was purchased back. In essence, Microline transferred
CASE 3: TECHNIC ENTERPRISES AND SONAR-SUN, INC.
MEMO
To: Recommendation Team
Re: Analysis of Technic Enterprises and Sonar-Sun, Inc.
To support Timken Brother’s buy/sell recommendation with respect to Technic Enterprises and Sonar-Sun, I
have analyzed their financial statements along three dimensions—solvency, earning power and persistence,
and earnings quality.
Solvency and Liquidity Position
Technic Enterprises Sonar-Sun, Inc.
Year 2 Year 1 Year 2 Year 1
years, while the quick ratio increased. Current liabilities almost doubled at the same time inventory
balances fell, creating the fall in the current ratio. Increases in current assets other than inventory,
however, have helped Technic avoid a dangerously low current ratio. At 2.44, Technic’s receivables
turnover is fair. For improved liquidity, receivables should be turning over more quickly than every 150
days. Recently, however, the receivables balance has grown while its bad debts allowance has not,
suggesting that part of the receivables balance may be overstated.
Despite additional common stock issued of $5,000,000, debt increased when a $5,000,000 note was issued
to buy Wallingford Atlantic. This has only further weakened an already poor solvency position. Unlike
Technic, however, Sonar-Sun does maintain a very strong receivables turnover ratio of 9.39, or turns over
every 38 days. While Sonar-Sun does not separately report on its allowance accounts, there are no signs
In contrast to Technic, Sonar-Sun has an even weaker liquidity position. Sonar-Sun has a balance sheet
consisting mainly of inventory and debt. While its solvency is not as weak as Technic’s, it is nevertheless
weak. Sonar’s choice to pay a large cash dividend rather than improve its solvency position is also not a
Earning Power and Persistence
Technic Enterprises Sonar-Sun, Inc.
ROA 0.09 0.13
ROE 0.25 0.36
Technic Enterprises performed well relative to its level of assets, equity, and sales. Each of these ratios
suggests Technic earns profits efficiently. Further, at 3.37 or every 108 days, its inventory turnover is good.
Further, the reduction in inventory has helped Technic achieve a good inventory turnover ratio. However,
given the nature of its inventory and a recent history of a write–down, Technic would face less risk of
In addition, a favorable translation gain added another $750,000 to income. Together these items account
for all of Technic’s earnings. There is reason to be concerned because none of these items is essential to
Technic’s operations or can be expected to persist in the future. Accounting methods cannot be changed
annually nor can sales of assets occur frequently. Finally, the translation gain may easily turn into losses
next year. Given that the net income would have decreased to almost nothing without these items
the unfavorable translation of the peso. With the exception of the write-downs of inventory and equipment
equal to $5,000,000, which are part of normal operations, most of Sonar’s income of $20,700,000 should
persist in the future. Only $4,000,000 of the $20,700,000 was earned by EDM Suppliers, an affiliate not
under control of Sonar. Note that unlike Technic, Sonar does not have other revenue and expense items
hidden in a miscellaneous income statement items.
does not appear to have good earnings power or persistence of positive income. Based on these factors, I
rate Technic a 3 on earning power and persistence. In contrast, Sonar–Sun earned positive income mostly
due to its own primary operating activities. Also, some of its losses or expenses are not expected to
persist in the future. For these reasons, Sonar–Sun earns a 7.
Earnings Quality
depreciation expense each year. Fifth, allowances for uncollectible accounts may not be sufficient. The
reported allowance decreased in half even though the receivables balance almost doubled.
Unlike Technic, Sonar’s accelerated depreciation methods result in an earnings amount that reflects
expenses in the most conservative way. Neither Technic nor Sonar appear to manage their short–term
investment portfolios for reporting purposes. Further, Technic uses FIFO inventory cost flow assumption,
CASE 4: AVERY CORPORATION
Evaluation of the CEO’s letter
Immediately below is a chart containing financial ratios computed on the financial statements of Avery
Corporation. The following discussion assesses earning power and solvency and, in so doing, addresses
the specific questions posed by Sellers. The solution concludes by summarizing the evaluation of the
CEO’s letter to the shareholders.
Financial Ratios for Avery Corporation
Year 3 Year 2 Year 1
Return on equity .063 .078
Quick ratio 1.95 4.19 2.04
Receivables turnover (days) 110 89
Receivables turnover (times) 3.32 4.12
Inventory turnover (days) 302 228
Inventory turnover (times) 1.21 1.60
Debt/equity .66 .73 1.58
Financial leverage .026 .038
Earning Power Assessment
Although reported net income appears to have increased ($5,626 to $7,333), earning power dropped
off substantially. First, three return ratios (ROE, ROA, and EPS) using reported net income show a
inventory turnover slowed to only 1.21 times per year, indicating that there are a number of slow-
moving inventory items, and additional inventory write-offs may be necessary in the future.
Proper income statement disclosure, which is not followed by Avery, should highlight net income from
operations, excluding the inventory write-down, income from the affiliate, the gain on the sale of
considered as such under generally accepted accounting principles. Rather, it is a normal and recurring
risk of business operations.
Solvency Assessment
The solvency, activity, and capitalization ratios point to a potential solvency problem. The current and
quick ratios have decreased from the first years shown, receivables turnover has slowed (suggesting
A closer look at Avery’s receivable and payable activity indicates that cash collections from receivables
totaled $105 million ($35 million + $115 million – $45 million), while sales totaled $115 million. This
combination increased net accounts receivable by $9.95 million for the second year in a row. Cash
payments for accounts payable totaled $67.7 million ($8.2 million + $75.5 million – $16 million), while
purchases totaled $75.5 million. This combination increased payables by $7.8 million. Thus, receivables
The issuance of a common stock dividend is also troublesome. It appears to have been issued in lieu of
a common stock cash dividend. The 10 percent dividend totaled a common stock issuance of 350,000
shares because 3.5 million common shares (5 million – 2 million – 1.5 million + 1 million + 1 million)
were outstanding at the time of the declaration. The issuance had no effect on the assets or liabilities
of the company, and it had essentially no effect on the wealth levels of the shareholders. It may have
1. In the latest year Avery did not demonstrate strong earning power.
3. The acquisition of Buckeye was financed primarily by a preferred stock (debt?) issuance and the
4. The shareholders have not prospered and, in fact, received only a stock dividend in the last year.
6. Persistent earnings are not sufficient to cover the company’s annual interest payments.
Questions
1. Net income increased from $5,626,000 to $7,333,000 while EPS decreased from $3.75 to $1.90. Even
without the extraordinary loss of $1.30, EPS from continuing operations was only $3.20, still less than
EPS in the prior year. The reason for the drop is that the number of shares outstanding increased. Avery
Number of
Outstanding Shares
Balance, Beginning 5,000,000
Less: Treasury shares—note 9 (2,000,000)
Treasury shares—note 9 (1,500,000)a
Balance 1,500,000
2. As outlined above, the 10% stock dividend resulted in the issuance of 350,000 shares. Stock dividends
3. The company issued $5,000,000 in bonds for $4,385,500 resulting in an effective market yield of 10%.
The call feature of the bond allows the bonds to be called beginning in the fourth year for 2% above the
4. Based on Avery’s latest consolidated balance sheet, Avery has total liabilities of $85,626,000 and total
equity of $129,959,000. This results in a debt/equity ratio of 0.65. The ratio is not an accurate measure
of the company’s actual debt position because it does not include a number of other debt-like events.
The company’s debt/equity ratio could be grossly understated. First, Avery makes $10 million in lease
payments each year. Footnote (8) suggests that the lease contract may meet the criteria for a
capitalized lease. If we assume a 10 percent discount rate and that these lease payments are required
for the remainder of the firm’s life, a $100 million ($10,000/.10) liability could be added to Avery’s
increase the debt/equity ratio from 0.65 to as much as 3.0.
It is also not likely that Avery will exercise its options to call its outstanding bonds. First, the call price
5. The footnotes disclose sales of $115,000,000 in the year. This represents sales earned, and since all
sales are made on credit, it does not necessarily measure cash collected from customers.
The actual amount of cash collected from customers can be calculated as follows:
Likewise, the amount of cash paid to suppliers for inventory can be calculated as follows:
Cost of goods sold $60,500,000
Plus: Increase in inventory (before write-down) 15,000,000
Purchases $75,500,000
6. While current assets have increased due to inventory and accounts receivable, it is not necessarily a
good sign. Increases in inventory may mean sluggish sales and high inventory storage costs. The
7. Latest year revenues consist of sales that have fallen from the prior year, affiliate income, a gain on the
sale of equipment, and revenue from special services (note 1). The latter three sources of income
accounted for almost $16,000,000 of Avery’s revenue but are not expected to persist in the future as
part of the primary operations.
8. Purchase price (note 4) $65,000,000 ($50 million cash & $15 million stock)
Less: Goodwill purchased
9. Cash (statement of cash flows) 20,000,000
Accumulated Depreciation ?
Equipment (note 3) 20,000,000
10. Pension expense $10,000,000
CASE 5: ZENITH CREATIONS
Re: Evaluation of Zenith’s financial condition
Zenith Services is a potential acquisition candidate of several companies. Offers from buyers will reflect
their assessments of Zenith’s financial condition and performance. So that Zenith can evaluate offers
received and to understand how these users may be evaluating Zenith, I have prepared (1) an evaluation of
Zenith’s financial condition and performance and (2) an analysis of the financial statement effects of several
proposed actions.
Financial Condition
the retirement of half a note issuance, the net loss has caused its debt/equity ratio to increase from 0.83 to
0.90. This means that Zenith is financed with approximately equal amounts of debt and equity. However,
this ratio may grossly understate Zenith’s debt position. First, Zenith has an operating lease for $8,000,000
each year. Capitalized at a 10% rate results in an additional $80,000,000 of debt. If these leases were
capitalized, the debt/equity ratio would approach 2.0. Also, in the latest year Zenith issued net $15,000,000
of preferred stock (500,000 shares at $30 each), which resembles debt but is not classified as debt on the
appear to be stable, and there are no signs of significant collection problems. The 50% increase in bad debts
and the need to write off an uncollectible account suggest only limited problems with granting credit to
customers.
Zenith may have a problem with the quick sale of inventory. Its inventory turnover ratios of 1.93 and 2.04 are
satisfactory but need to improve. A turnover ratio of 2.0 indicates that it takes 182 days to turn over
Performance
Reported net income has dropped significantly from $19,529,000 to a loss of $11,510,000. One of the
largest contributors to this drop was the fall in operating revenue of $16,000,000, including a decline in
sales of $10,000,000. While the special services revenue and the loss on the sale of equipment (note 1) may
not persist into the future, the decline in sales indicates that Zenith Services’ primary source of revenue and
earnings may not persist into the future.
The other primary contributor to the decline in net income is the restructuring charge of $15,000,000.
While this charge is not extraordinary, it is not part of the normal operations and should not persist. In
addition, users may positively view the charge if the restructuring activities contribute to improved
loss, Zenith paid a stock dividend. Some users may view this dividend in lieu of a cash dividend as a ploy to
appear as a healthy company issuing dividends. Stock dividends, however, do not add to the wealth of the
investor. As they dilute potential ownership and reduce retained earnings, potential investors may, in fact,
not view the stock dividends favorably.
Also, Zenith’s investment in Lyon Real Estate through the issuance of common stock significantly diluted the
Management Actions
Zenith’s management is considering a number of actions, some of which significantly affect the financial
statements and assessments of financial health. Below are discussed the effects of each of these actions.
(1) Purchase treasury stock at current market price.
The purchase of treasury stock requires the use of cash. While Zenith has sufficient cash available, it would
be wiser to use the cash to pay off outstanding payables. On the other hand, if Zenith anticipates improving
its health and its stock price, it may be able to secure additional cash by purchasing stock now at a low price
(2) Write off a relative large uncollectible accounts receivable.
(3) Issue a 20% stock dividend.
A 20% stock dividend would amount to 2,311,000 shares and reduce retained earnings by market value of
the shares. Since retained earnings is only $23,488,000, a stock dividend would reduce retained earnings to
(4) Redeem the remaining notes payable for $23,200,000.
Currently, notes payable has a book value of $19,665,000. If Zenith redeems the note for $23,200,000, it
will realize an extraordinary loss of $3,535,000. The cash paid will contribute to a decreased current ratio.
(5) Sell the real estate received in the acquisition of Lyon Real Estate for $12,000,000.
When Zenith acquired Lyon Real Estate, it acquired real estate worth approximately $5,010,000.
Price $25,010,000
are more likely to perceive the gain from this sale as more persistent than the gain from the retirement of
debt. Given the small return currently being earned on this investment, the sale may be a wise action.
(6) Change the inventory cost flow assumption from LIFO to FIFO.
A change in the accounting method from LIFO to FIFO requires retroactive adjustments to the comparative
CASE 6: PIERCE AND SNOWDEN
MEMO
To: Recommendation Team
Re: Analysis of Wellington Mart and Wagner Stores
To assess whether Pierce and Snowden should extend credit to Wellington Mart and Wagner, I have
analyzed their financial statements along three dimensions—solvency, earning power and persistence, and
earnings quality.
Solvency position
Wellington Mart Wagner Stores
Year 2 Year 1 Year 2 Year 1
Current ratio 0.47 1.09 1.97 3.43
Wellington Mart is experiencing decreasing liquidity and solvency. Both its current and quick ratios have
fallen significantly between the years shown. As of the end of the most current year, Wellington’s current
and quick ratios are a dangerously low 0.47 and 0.39, respectively. A large contributor to the fall in the
At the same time, its total debt/equity ratio has increased from 0.62 to 0.80. Part of the increase is due to
the issuance of a new note for $13,900,000. While the $6,200,000 increase in debt is due to its adoption of
a defined pension plan, the ratios may, in fact, be grossly understated. First, Wellington has an operating
lease, which requires annual payments of $12,000,000. Given that it has an option to buy the facilities at
the end of the lease term for 25% of the market value, this lease may be more properly classified as a
On the positive side, due to an increasing interest rate, the market value of its bond payable is actually
Also, despite its net loss, Wellington paid a stock dividend. This dividend in lieu of a cash dividend may be a
ploy to appear as a healthy company issuing dividends. Stock dividends, however, do not add to the wealth
of the investor. As they dilute potential ownership and reduce retained earnings, potential investors may, in
1.80. Unlike Wellington, Wagner’s liabilities include capital leases of $4,771,000. In addition, however,
Wagner also has operating lease payments of $6,200,000 per year. If capitalized at a discount rate of 10%,
an additional $62,000,000 in debt would be included on Wagner’s balance sheet. Also, unlike Wellington,
Wagner has only $5,000,000 in preferred stock, which may have features and obligations similar to debt.
On the positive side, due to an increasing interest rate, the market value of its bond payable is actually
lower than stated on the balance sheet. Like Wellington, if Wagner calls these bonds, it will realize an
extraordinary gain on the retirement of the bond.
Earning Power and Persistence
Wellington Mart Wagner Stores
Inventory turnover 9.00 1.93
ROA –0.04 0.09
Wellington experienced a significant net loss of $10,878,000. A large contributor to this loss was a
restructuring charge of $9,000,000. While this charge is not extraordinary, it is not part of the normal
operations and is not expected to persist in the future. In addition, users may positively view the charge if
the restructuring activities contribute to improved operations. The loss would have been even greater,
Based on their income statement, it appears as if Wellington’s selling and administrative expenses are
contributing to the loss situation. There is not evidence that these significant expenses are not expected to
persist in the future. The loss of $1,600,000 is more appropriately classified as a normal recurring part of
Wagner has a good level of earning power. All three earning power ratios (ROA, ROE, and EPS) are strong. In
addition, the return on sales and times-interest-earned ratio suggests Wagner is financially strong and is
utilizing its assets effectively.
Note that Wagner has profitability on operating income of $13,250,000, versus $3,622 for Wellington on
operations, should be separately disclosed, given its magnitude of $3,200,000. If these items had been
properly classified, operating income would have been lower and users would realize that the $3,200,000
loss from the discontinued equipment is not expected to persist.
Earnings Quality
Wellington has presented its income statement and made decisions that favor the presentation of its
performance. First, hidden within “other revenues and expenses” is the inventory write-down of
$1,600,000. This is an ordinary part of business and should be reported in the operations section. Second,
selling and administrative expenses are a significant $45,000,000 but are not described further. Clearly, this
stable so that this difference is not significant.
Summary: Wellington’s earnings quality is not overly inflated by items at the discretion of management.
Estimated expenses do not appear to be understated, and except for a single gain on a security, some