What is “Quality of Earnings”?
Quality of earnings refers to the income generated from the core operations (recurring) of the business and does not include the one-off revenues (nonrecurring) generated from other sources. Evaluating the quality will help the financial statement user make judgments about the “certainty” of current income and the prospects for the future.
- Quality of earnings report is primarily used to assess the accuracy and sustainability of historical earnings as well as the achievability of future projections.
- In the case of acquisitions, valuations are typically based on a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). It is, therefore, critical for a buyer to understand historical earnings, trends, critical assumptions used in forecasts, and the sustainability of earnings.
- For an income measure to be considered of high quality, it must reflect cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , and it must be sustainable. Earnings that are “tied up” in accounts receivableIn Accounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. , for example, do not have much value because, despite being recognized, they have not yet been realized. Similarly, earnings that are not sustainable due to understated expenses due to an unfilled executive position, as an example, would overstate sustainable earnings.
Let’s say that Company ABC’s net income increased by 130%. Its sales jumped up by 200%, while it managed to bring down its general and administrative expenses by 10%. On the contrary, say that Company XYZ’s sales were more or less flat, its expenses rose only by 5%, and its net income increased by 130% after it changed the way some of its assets and inventory depreciated.
- It is prudent to say that company ABC has a better earnings quality as compared to XYZ because Company ABC’s earnings are from genuine improvements in core operations, i.e., the sale of products.
- Company XYZ was able to record a similar rise in its net income mainly as a result of the accounting changes (changed the depreciation calculation), the earnings increases are little more than paper profits. It is important to note that company XYZ hasn’t done anything illegal or wrong, but its quality is lower than that of company ABC.
Factors Affecting Quality of Earnings
According to a survey conducted by the Emory University, 94.7% of CFOs think that earnings are either very important or somewhat necessary for investors in valuing the company. It is difficult to define the quality of earnings and, although there are no definitive criteria by which to evaluate it, there are many factors that can be considered in assessing the earnings.
- Taken as a whole, it can be summarized as the degree to which earnings are cash or noncash, recurring or nonrecurring, and based on precise measurement or estimates that are subject to change.
- If a company has managed to increase its earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. every year by improving cost efficiencies or sales generated from a marketing campaign, that company would have a high-quality income. If a company’s earnings are linked to outside sources such as increasing commodity prices, then the company would be seen as having a low quality of earnings.
- Also, a company may report a growth in sales, but this may be due to growing credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. . Usually, analysts are not fond of loose credit policies and prefer organic growth in salesOrganic Growth In SalesOrganic growth is the rate of growth that a company achieves by increasing sales revenue by increasing volume of products sold or by achieving greater operational efficiency leading to a reduction in the cost of production or any other internal improvement.. A company may have a high net income, but at the same time, negative cash flowsNegative Cash FlowsNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period. from operations. This can be done through artificial means.
Indicators of Overall Earnings Quality
The financial statementsThe Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. can provide a few signs that readers can use to assess earnings on a high level. These are (but not limited to):
- Year to year or quarter to the quarter consistency of accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.
- The overall degree of estimation or subjectivity in determining earnings
- The trend in reserve balances
- Transparency of disclosures
- Discussion of nonrecurring, unusual transactions
- Presence of pro forma measures of earnings
- Disclosure of related-party transactions
- The ratio of net income to cash from operations
Quality of Earnings Measures
It should also be noted that companies may manipulate earnings measures such as earnings per share and the price-to-earnings ratio by buying back shares of stock, which reduces the number of shares outstanding. Due to this, a company with declining net income may be able to post earnings-per-shareEarnings-per-shareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. growth. Because earnings go up, the price-to-earnings ratioPrice-to-earnings RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It mainly concerns when companies take on additional debt to finance stock repurchases.
There is no single characteristic to measure the quality of earnings. However, the financial statement users, especially audit committeesAudit CommitteesA company's audit committee is a group of non-executive directors who are in charge of ensuring the integrity of internal controls, auditing, and financial reporting procedures. It works under the supervision of the Board of Directors and strives to sustain the corporate governance system. and management, should be prudent in evaluating the quality of financial reporting. Specific indicators and characteristics should be focused on assessing its quality.
Quality of Earnings Video
This has been a guide to the Quality of Earnings. Here we discuss the key factors of earnings quality and its top indicators along with practical examples. You can learn more about accounting from the following articles –