Saturday, November 5, 2011

Quality of Earnings: Chapter 9

Investors rely heavily on the financials that companies release. But managements have significant leeway when it comes to creating its results. In this book, Thornton O'Glove tells investors how to judge the quality of a company's earnings, in order to both protect against fraud and find value.

This chapter is about debt and cash flow. While earnings numbers are what investors usually focus on, investors should ensure a company is relatively safe before investing. Analyzing the company's leverage situation and its cash flow can help in this regard.

For debt analysis, O'Glove argues that investors should look at debt to capital ratios and interest coverage ratios. This will allow the investor to determine if the company has taken on too much leverage, which can amplify losses (as well as gains).

Investors should also have a strong understanding of where the company's cash flow is coming from. Earnings growth with negative cash flow from operations, for example, could be a red flag.

O'Glove provides some examples from some high-flying stocks where he has seen trouble ahead by analyzing these line items.

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