How to Improve Profitability and Retain More Cash: Addressing Poor-Quality Earnings
Chris Peden, CPA, CMA, CFM
I help small business owners grow their profits, cash flow and reduce their taxes by understanding their financials and creating an action plan to get there. Free Financial Assessment available (Link in “About” below).
As a small business owner, it's essential to understand how the quality of your earnings can affect your profitability and cash flow. Poor-quality earnings can lead to numerous financial challenges and make it difficult to maintain a healthy business. With my experience as a CPA/CFO, I've helped many clients recognize and address these issues effectively. Let's explore how you can do the same for your business.
Detecting Early Warning Signals
The first step is recognizing the early warning signs of poor-quality earnings. A lower price/earnings ratio can indicate that the market has little confidence in your company's future profitability. Higher financing costs and the unavailability of suitable financing are red flags that suggest lenders view your business as high-risk. If you find that higher compensating balances and security are required for loan agreements, or if there's a deterioration in your company's bond rating, these are signs that your earnings quality might be poor.
Prognosis and Diagnosis
To diagnose poor-quality earnings, look for factors such as unrealistic accounting policies and estimates, inadequate provision for the maintenance and enhancement of earning power, and instability in operations and earnings. Other indicators include unjustified reductions in discretionary costs, a decline in profitability, and subjective or uncertain accounting estimates. High cash-realization risk of assets, a high fixed cost structure, and susceptibility to the business cycle also contribute to poor earnings quality. Additionally, watch for a low ratio of cash earnings to net income, a low ratio of residual income to net income, a high ratio of sales returns and allowances to sales, deficient return on assets, and a lack of diversification.
Analysis and Evaluation
Poor-quality earnings occur when earnings do not reasonably reflect the business operations within a period. For example, if two competing companies use different accounting policies, adjusting their net incomes to a common basis can reduce diversity in accounting and provide a clearer picture. Footnotes in financial statements can help with this restatement process.
A weak relationship between sales and net income may indicate that a company is manipulating its earnings. For instance, if a company's ratio of net income to sales fluctuates significantly over several years, it might suggest earnings manipulation.
Example Scenario
Let's say a company's reported earnings per share (EPS) is $10, but numerous low-quality components inflate this figure. By adjusting for these components, you can arrive at an "acceptable quality" EPS. For example, unjustified cutbacks in discretionary costs, a decline in the ratio of bad debts to sales, and one-time gains should be deducted from the reported EPS to reflect a more realistic figure. If the adjusted EPS is $9.10, it indicates that the reported earnings include several low-quality items.
Remedy
To improve the quality of your earnings, consider these strategies:
Incur expenditures needed for future successful operations. This includes investing in maintenance, research and development, and other areas critical to long-term success.
Make realistic expense and liability provisions. Avoid underestimating expenses or liabilities, which can mislead stakeholders about the true financial health of your business.
Provide for realistic recognition of revenue. Ensure that your revenue recognition policies reflect the actual earning process and are not overly optimistic or manipulative.
Avoid cutting costs necessary for successful operations. While cost-cutting can improve short-term profitability, it can harm your business in the long run if critical expenditures are reduced.
Write-down overstated assets. Adjust the value of assets on your balance sheet to reflect their true market value, which can provide a more accurate picture of your financial position.
Preventive Measures
Implementing preventive measures can help you avoid poor-quality earnings in the future. Let's talk about how you can avoid high cash-realization risk in the future. First, it's important to steer clear of acquiring assets that are difficult to convert to cash. You should also be cautious about spending too much on things like leasehold improvements, as these can tie up your capital without providing quick returns.
When considering new ventures, avoid high-risk companies. Instead, focus on controlling your work-in-process levels to prevent capital from being tied up in unfinished goods. Be wary of costly startup operations that might not generate quick returns and avoid moving production facilities, which can cause operational disruptions.
It's also crucial to have strong credit policies in place for both new and existing customers. Regularly review and improve these policies to minimize risks. Additionally, try to limit your business operations in politically and economically unstable regions, as these areas can introduce significant risk.
Investing wisely is another key factor. Avoid making low-quality investments that might not provide good returns. Finally, establish a committee to evaluate and appraise any major asset acquisitions. This can help ensure that your investments are sound and aligned with your risk management strategy.
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Ripple Effects
Poor earnings quality can have significant ripple effects on your business. It increases the cost of borrowing and the debt-to-equity ratio, as investors are less inclined to buy your stock due to perceived lower quality. This can lead to a decrease in the market price of your stock and bonds, a lower credit rating, and higher collateral requirements for loans. Poor earnings quality also increases the risk of business failure and can lead to higher employee turnover due to instability.
Implementation Tips
1. Monitor Financial Health Regularly: Keep an eye on your financial statements and key performance indicators to detect early warning signs of poor-quality earnings.
2. Use Realistic Accounting Methods: Ensure that your accounting policies and estimates are realistic and reflect the true financial position of your business.
3. Invest in Necessary Expenditures: Avoid cutting costs in areas critical to long-term success, such as maintenance, research, and development.
4. Adjust Asset Values: Regularly review and adjust the value of your assets to reflect their true market value, providing a more accurate picture of your financial position.
5. Strengthen Credit Policies: Review and improve credit policies to minimize the risk of uncollectible receivables.
6. Seek Professional Advice: Consult with a CPA or financial advisor to develop a comprehensive strategy for improving the quality of your earnings.
Action Items for Business Owners
To ensure your business remains profitable and retains more cash, take these actionable steps:
1. Conduct a Financial Health Check: Regularly review your financial statements, focusing on the quality of earnings and key performance indicators.
2. Evaluate Your Accounting Practices: Ensure your accounting policies and estimates are realistic and reflect the true financial position of your business.
3. Invest in Critical Areas: Avoid cutting costs in areas critical to long-term success, such as maintenance, research, and development.
4. Optimize Asset Management: Regularly review and adjust the value of your assets to reflect their true market value.
5. Strengthen Credit Policies: Improve your credit policies for both new and existing customers to minimize financial risks.
6. Seek Professional Advice: Consult with a CPA or financial advisor to develop a comprehensive strategy for improving the quality of your earnings.
By understanding and addressing poor-quality earnings, you can significantly improve your business’s financial health. Over the years, I've helped many clients navigate these challenges and achieve financial success, and I'm confident you can too. Stay proactive, monitor your financial health, and don't hesitate to seek professional advice when needed.
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