Quality of Earnings

Assessing the quality of reported earnings using cash flow data: Although much of the work of an equity analyst involves quantitative analysis, some analysts also engage in various qualitative analyses to help them assess the persistence of a firms current earnings. Consider, for example, the case of BLOCKBUSTER ENTERTAINMENT CORPORATION. In 1989, Lee J. Seidler, a senior analyst with Bear, Stearns & Co., issued a research report critical of Blockbusters earnings. Mr. Seidler observed that although BLOCKBUSTERS 1988 net income was $15.5 million and its cash flow from operating activities $48.5 million, his review of the firms cash flow data revealed that BLOCKBUSTERS purchases of new videocassette rental inventory had been classified as an investing activity rather than as an operating activity on the companys statement of cash flow. Presented below is selected financial statement information for BLOCKBUSTER:

In Millions Net income Cash flow from operations Purchases of videocassette rental inventory

1988 $15.6 48.3 (51.3)

1987 $4.09 10.3 (14.3)

Discuss how the statement of cash flow can be used to help evaluate the quality of a companys reported earnings. Describe how BLOCKBUSTER cash flow data can be used to illustrate this. Do you agree with BLOCKBUSTERS cash flow classification of its video inventory purchases affect its cash flow from operations?