FirstRate Company and subsidiaries Quality of Earnings Analysis (U.S. dollars in
ID: 2493487 • Letter: F
Question
FirstRate Company and subsidiaries Quality of Earnings Analysis (U.S. dollars in thousands) Fiscal year ended December 31, 20X1 20X2 20X3 20X4 20X5 1 Net income $23,900 $24,900 $22,000 $18,100 Adjustments to reconcile net income to OCF Depreciation of property, plant, and equipment 10,500 11,200 11,700 12,000 Gain on disposal of equipment – – – – Loss on sale of equipment 900 – – – Changes in working capital accounts Decrease (increase) in accounts receivable, net (2,000) (8,000) (11,000) (13,000) Decrease (increase) in inventory (4,400) (14,000) (14,900) (17,700) Increase (decrease) in accounts payable 2,200 11,100 10,100 15,400 Increase (decrease) in accrued income tax. payable (300) 100 (400) (400) Increase (decrease) in accrued interest payable 100 200 400 600 Net cash provided by (used in) operating activities $30,900 $25,500 $17,900 $15,000 Ratio of OCF-to-Net income Cumulative ratio of OCF-to-Net income Student’s narrative analysis (Limit the length of your analysis to a maximum of 150 words) Please provide your word count here Your response here (please do not modify the formatting, fonts, colors, and so forth in this document template)Explanation / Answer
Ratio of OCF to NEt income = Operation Cash Flow / Net Income
* 20x1 => 30900 / 23900 = 129.28%
* 20x2 => 25500 / 24900 = 102.41%
* 20x3 => 17900 / 22000 = 81.36%
* 20x4 => 15000 / 18100 = 82.87%
Although earnings can consist of both cash and non-cash adjustments, but earnings based on an increase in a company's cash position are of a higher quality than those which are not. Luckily, there's a useful ratio we can deploy against the income statement to determine the quality of a firm's reported earnings: Operating Cash Flow (CFFO) to Net Income.
Operating activities are the actions a company takes pursuant to its normal, or core business activities. For instance, a PC company like Hewlett-Packard (HPQ) sells computers and printers as it's core operating activity; if HP sold a piece of land it owned, that cash increase would not appear as cash provided by operating activities. Once you've located your CFFO number, move over to the income statement and find net income. Make sure you use the after tax figure. Divide the two, and there you have your ratio.
When a company's CFFO to net income ratio rises above 1 (i.e above 100%), it is indicative of a strong ability to fund it's activities through generation of operating cash flow. In other words, a higher ratio means that the firm's earnings are of a higher quality.
A CFFO to net income ratio which remains below 1 (i.e below 100%), for an extended period of time could be an indication that the company will need to raise money to fund its operations. Thus, A decline in this ratio over time may indicate that the company is experiencing cash flow problems.
IN the given Qustion, OCF-to-net income ratio is more than 100% in 20x1 & 20x2 which means company's cash earnings are of high quality & it is not facing any cash issues. And as soon as it declines below 100% in 20x3 & 20x4, this indicates company is experiencing cash flow issues from operational activities.
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