Question

Dealing with Financial Statment Analysis...

What happens when a firm’s earnings and cash flow diverge to an extent that becomes unsustainable?

Using an example from W. R. Grace, discuss how increased earnings may not have an effect on stock price of a firm?

Answer 1

1. This happens when earnings are being reported before cash flow happens. Eventaully, this will show company in a positive light even though they don't have enough cash to pay their obligations at the moment. If it diverges too strongly, the company will have to revise their financial statements and it can deter investors or lead to plunge in stocks. Worstt case scenario, if company has short debt than it won't be able to pay even though it has a good PAT and declare bankruptcy.
2. If a firm has already good earnings, an increase in earnings which doesn't beat the market expectation can even lead to decline in price of stock. W. R Grace tried to manipulate this market behavior by reporting less earnings than actual during its "good days" and reporting these profits in their statements during "bad days", thus smoothening out their return graph. This was a SEC violation and W.R. Grace was penalized heavily.