Energy Sector: Integrated Oil & Gas, US Stocks - Quality of Earnings, Overview and Inventory

I'm going to start our financial analysis by looking at the quality of earnings calculations but before I go any further, I need to give credit where credit is due.  I am indebted to Baruch Lev and S. Ramu Thiagarajan.  I extracted these indicators from their article "Fundamental Information Analysis", JSTOR, Journal of Accounting Research, Vol. 31, No. 2.  Thank you Dr. Lev and Dr. Thiagarajan.

The five indicators I look at are:

• Inventory,
•  Accounts Receivable,
• Research & Development, 
• Capital Expenditures,
• Gross Margin,
• Selling & Administration Expense.

As I mentioned, I use these six indicators to gauge the trust-worthiness of the financial statement themselves.   Although the importance is probably self-evident, I'll provide an example.

Let's say an investor finds a security that for some reason looks appealing - the earnings are growing at an impressive pace.  It is important to keep in mind that net income is an abstract concept.  There are a number of judgement calls made before arriving at that figure.  Some are benign, an honest reflection of the business or industry in which the company operates.  Some are not, some are manipulative.

For example, many frauds and subsequent company implosions have occurred around receivables.   Receivables can be aggressively recorded and used to artificially inflate earnings.

The one I'm going to discuss today is inventory.  Changes in inventory relative to other financial statement factors can tell a story.  Here are some examples:

• Inventory increases that are greater than cost of goods sold increases can be negative sign as it can suggest trouble generating sales,
• Inventory increases can hint at future earnings weakness as prices are cut to move excess inventory,
• Inventory build-ups may indicate the need to write off obsolete products.

All of this tells us that we don't want to see inventory growing faster than sales. If it is, it's a red-flag.

I'm going to go into detail on the inventory quality of earnings calculation in this post.

When I set up this portfolio in Verdasis, I used the securities in Google's similarly named energy sub-sector, integrated oil & gas.  At the time, there were 23 securities.  If you want the list, you can get it here:
http://www.google.ca/finance?catid=us-60884163

I set up the analysis template (where the user tells the software what financial information they want) to capture sales and and inventory information for the current period plus the last previous two years, or in other words:

• Total Revenue, Y
• Total Revenue, Y-1
• Total Revenue, Y-2
• Total Inventory, Y
• Total Inventory, Y-1
• Total Inventory, Y-2.

Once the data has been sent to a spread sheet, we have to make five calculations:

• Expected Sales,
• Expected Inventory,
• % change in sales,
• % change in inventory,
• % change in sales - inventory.

Estimating or guessing on what the future sales might be isn't an exercise I would particularly like to undertake, so it is fortunate that Expected Sales and Expected Inventory can be proxied by taking the average of y-1 and y-2.  The value for expected sales is then compared to this year's sales with a simple return formula:

(Actual Sales in current year - Expected Sales) / Expected Sales

If the actual sales is greater than the expected sales, then the figure is a positive number, if not, it is negative.

Do the same calculations for inventory.

We then want to see how the numbers are moving in relationship to one another.

The best and fastest way to do this is just to subtract:

% change in sales - % change inventory.

If the number is positive, excellent.  If it isn't, red flag.

The final step is to summarize the result and a quick and meaningful way.  I use a 1, 0 and -1 system.  If my indicator is positive, I give a 1 rating.  I use -1 for a unfavorable rating and  0 for a null or neutral result.

You can click the link below to view the finished spreadsheet

https://docs.google.com/spreadsheet/ccc?key=0Ap4zxzjwKsV6dHg3X0FoWDh0TDZSV0Rxc0NQUFk3cmc#gid=0


The next post will be brief, as it will go through the Accounts Receivable calculation, which is identical to  Inventory.

Thank you so much for reading.  If you have any questions, please do not hesitate to ask!