Will American Public Education's Earnings Go to the Head of the Class?

When looking at earnings quality, we at The Motley Fool have two databases -- EQ Scan and EQ Score -- that help us uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important to help investors protect against losing their hard-earned money.

The EQ Score database assigns an index rank to the company, from 1, for the lowest quality, to 5, for the highest. As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward. Today we'll look at American Public Education (Nasdaq: APEI), which reports earnings after the market closes tomorrow. The EQ Score ranks American as a "4," equivalent to a "B" letter grade. Let's take a closer look.

Analysts expect the online postsecondary educational services company to report $74.89 million in revenue and $0.48 in EPS, which will be an improvement of 11.63% over last year's reported $0.43 for the same quarter. If the company meets its revenue target, it will be a 27.7% increase from last year's $58.66 million.

American competes with several companies that offer postsecondary education to students of all ages, including Apollo Group (Nasdaq: APOL), and DeVry (NYSE: DV), among many others.

Apollo ranks as a "2," and DeVry gets a "3." Let's see why.

American earns a "B" for its efforts
American's income-statement metrics look positive overall, as revenue is increasing both in terms of absolute dollars and year-over-year percentage gains.

American carries no inventory, so the cost of goods sold, or COGS, is composed of project-based labor hours. The company's project teams are becoming more efficient in delivering classroom instruction and other related services. The gross margin -- revenue minus the COGS -- is increasing. American's story is marred only by increasing selling and administrative, or SG&A, margins, forcing operating margins down. We'd also like to see the SG&A percentage lower but recognize the company must spend money to make money.

American has a healthy uptrend in operating cash flow and is improving its cash collection process, as seen in the drop of days sales outstanding from about 22 to 14, while the receivables trend is basically flat -- hence its "B" rating.

APEI Cash Operations data by YCharts

Apollo needs a gift from the gods
Let's compare the same metrics for Apollo as for American.

Apollo's income statement metrics make it clear that the company could use some divine intervention from its namesake. There aren't many good things to say here, except that the 2012 net profit margin returned to positive territory from the previous year.

APOL Cash Operations data by YCharts

Aside from revenue, cash flow is almost as important for analyzing the health of a business. Apollo's chart shows a general downward flow of all three metrics -- cash from operations, days sales outstanding, and accounts receivable. The company had total receivables on the books for the four quarters in 2010-2011 of $852.03 million, but only $813.33 million in 2011-2012, a decline of 4.54%. Yet revenue declined during this period by 7.54%, indicating that payment terms increased. Apollo earns a "D" rating and needs some tutoring.

I know why DeVry is awry. Do you?
The last company we'll review in the for-profit education space is DeVry.

DeVry's margins have deteriorated over the past two years, and in general the company's income statement displays somewhat bloated costs. Of the three companies under review, DeVry's gross margin is the lowest, which could be explained by DeVry's inability to set its prices high enough or possibly discounting to gain market share. Still, its operating and net profit margins are higher than Apollo's.

DeVry's receivables as a percentage of revenue have jumped from 31% to 37% to 47% year over year since 2010. One positive note is that days payable outstanding -- DeVry's bill-payment cycle -- decreased year over year since 2010 from 38 to 25 to 20 days, hence its "C" ranking.

DV Accounts Receivable data by YCharts

In the hierarchy of metrics affecting earnings quality, revenue is most important, and cash flow is more important than net income. In other words, Wall Street tends to focus on the wrong metric as the basis for its recommendations to buy, hold, or sell a stock. Since January, American's stock price has declined from $42.55 to $31.11 currently, or 26.89%. American's trailing P/E is 13.95. Last year's earnings came in at $2.23, and analysts expect the company to earn $2.36 a share this year, a 5.83% increase. Based on American's revenue and earnings targets, a positive price trend could be in school. As always, prudent Fools should make investment decisions based on consideration of earnings quality.

To stay current on whether American's earnings report meets, misses, or beats expectations, be sure to add it, or any of the other companies mentioned here, to My Watchlist, a totally free service offered by The Motley Fool that keeps you current on your favorite stocks.

• Add DeVry to My Watchlist.
• Add Apollo Group to My Watchlist.
• Add American Public Education to My Watchlist.