ACC 345 Module 3 Cash Flow and Earnings Quality Assignment Example

Profit Up, Cash Flow Down: Cash Flow Analysis and Earnings Quality at a Composite Fire Sprinkler Contractor

[Student Name]

Southern New Hampshire University

ACC 345: Financial Statement Analysis and Business Valuation

Module Three Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Profit Up, Cash Flow Down: Cash Flow Analysis and Earnings Quality at a Composite Fire Sprinkler Contractor

Introduction

In its latest year, the Atlanta-area sprinkler contractor reported record net income of $2,040,000, up 29 percent. Yet its cash balance fell by $400,000. For a buyer or a lender, that combination raises an immediate question: are the earnings real, in the sense of being collected in cash and likely to recur, or are they partly estimates that may not turn into cash? This assignment rebuilds the year's statement of cash flows, computes free cash flow and accrual measures and judges the quality of reported earnings (Dechow et al., 2010).

Operating Cash Flow Rebuilt

Table 1. Operating Cash Flow, Indirect Method (thousands of dollars)

Three items explain almost all of the gap. Receivables rose $1,630,000, much faster than revenue. Contract assets, revenue recognized on projects in progress but not yet billable, rose $440,000. And contract liabilities, billings received ahead of work, fell slightly, meaning customers prepaid less than before. Payables and accruals offset only a small part, about $520,000 of the $2,280,000 absorbed by the other working capital accounts.

Investing, Financing and Free Cash Flow

Table 2. Summary of Cash Flows (thousands of dollars)

Free cash flow was negative. The company spent $1,280,000 on vans, a fabrication shop expansion and inspection tablets, more than its operations generated, and it borrowed $450,000 while paying the family $630,000 in distributions. A year like this is sustainable for a growing firm, but not indefinitely.

Accrual Measures

Operating cash flow covered only 52 percent of net income, compared with about 90 percent the year before. The balance sheet accrual ratio, the gap between profit and operating cash scaled by the year's average assets, is $980,000 divided by $15,100,000, or 6.5 percent. Sloan (1996) found that firms with high accruals relative to assets tend to see lower future earnings, because profit that has not yet turned into cash fades faster than profit that has. A 6.5 percent ratio is not extreme, but it is a large change from the prior year and is concentrated in two accounts that depend on judgment. In the prior year the same ratio was close to 1 percent, so the composition of earnings shifted sharply toward accruals in a single year.

Why the Accruals Grew

The receivables increase has a concrete source. Two general contractors, one building a hospital wing and one a regional warehouse, account for $1.2 million of the increase. Both pay on 75-day terms and hold 10 percent retainage until their projects are complete. Retainage is a normal feature of construction contracts and is usually collected, but it lengthens the cash cycle, and if either project runs into disputes, collection could slip further.

Contract assets are a different kind of accrual. Installation revenue is booked as costs accumulate against each job's estimated total cost, so an estimate of total cost that is too low pulls revenue forward ahead of billing. Dechow and Dichev (2002) show that accruals tied to estimates are where errors most affect earnings quality, because they reverse when estimates are corrected. The company's two largest open projects account for most of the contract asset increase, and a review of their cost-to-complete estimates is the single most useful diligence step.

A Year-Over-Year View

One year of weak conversion would not be alarming on its own. What makes this year notable is the change. In the prior year, operating cash flow was about $1.4 million against net income of $1.6 million, roughly 90 percent conversion, and receivables grew roughly in line with revenue. This year conversion fell to 52 percent while revenue growth stayed near 11 percent. Revenue growth did not accelerate enough to explain the jump in receivables, so the explanation has to come from payment terms, specific customers or estimates, which is why the analysis turns to those accounts next. An analyst who saw only this year's statements would miss that the pattern is new.

Earnings Quality Judgment

The earnings are not illusory. Most of the gap between income and cash comes from receivables owed by creditworthy customers under normal construction terms, and the service segment, which is billed annually in advance or monthly, produces cash reliably. But a buyer should not treat the full year's increase in net income as recurring cash earning power. A reasonable adjustment is to look through the contract asset increase until the two large projects close and to underwrite a working capital need that grows with installation revenue. On that basis, earnings quality is moderate: good in the service business, dependent on estimates in the project business. A second year of similar conversion would move that judgment down; a return toward 90 percent would move it up.

Conclusion

The contractor converted only about half of its $2,040,000 net income into operating cash, and free cash flow was negative after capital spending. The gap traces to receivables on two large projects and to contract assets based on cost estimates. Neither indicates manipulation, but both reduce the share of this year's earnings a buyer should treat as persistent, and both deserve specific diligence before any valuation relies on them.

The finding also shapes how the company should be valued and financed. In a discounted cash flow model, the working capital tied up by growth must be treated as a cash outflow every year the business grows, not only this year, which lowers value relative to a model built on earnings alone. For a lender, the same finding argues for a borrowing base tied to eligible receivables, excluding retainage and balances over ninety days, rather than an unsecured line sized on earnings. Both responses accept the earnings as real while pricing the fact that they arrive in cash later than they appear in income.

References

Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2-3), 344-401. https://doi.org/10.1016/j.jacceco.2010.09.001

Dechow, P. M., & Dichev, I. D. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(s-1), 35-59. https://doi.org/10.2308/accr.2002.77.s-1.35

Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289-315. https://doi.org/10.2308/tar-9608042309