There are some key items which are not relevant to predict the earning power of a company. It is recommended that an analyst should remove such items from the earnings statement in order to assess true picture of earnings capacity of a firm. One such item is “Equity Income”: for example, Company ABC may have 25% ownership in company XYZ. Suppose XYZ earned $100,000 after tax income in 2010. Company ABC has $25,000 equity in 2010. Note the Company ABC does not receive cash and therefore the “equity income”, reported on the earnings statement, is a non-cash item. When computing CFO, equity income is subtracted from earnings before extra-ordinary items. Equity Accounting is applied when company ABC will have equity holdings of 20-50% in Company XYZ.
Another such item is called as “extra-ordinary item”, which is a “windfall” type capital gain or a loss. Elimination of such non-repeating items would both increase predictability and smooth out year over year earnings trends.
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