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 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, key assumptions used in forecasts and the sustainability of earnings.
- In order for an income measure to be considered of high quality, it must reflect cash flow and it must be sustainable. Earnings that are “tied up” in accounts receivable, 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.
Example
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 PQR’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 important 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 earnings 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 having a low quality of earnings.
- Also, a company may report a growth in sales, but this may be due to growing credit sales. Usually, analysts are not fond of loose credit policies and prefer organic growth in sales. A company may have high net income but at the same time, negative cash flows from operations. This can be done through artificial means.
Indicators of Overall Earnings Quality
The financial statements can provide a few indicators 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 policies
- Overall degree of estimation or subjectivity in determining earnings
- 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-share growth. Because earnings go up, the price-to-earnings ratio goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It is particularly concerning when companies take on additional debt to finance stock repurchases.
Conclusion
There is no single characteristic to measure the quality of earnings. However, the financial statement users, especially audit committees and management, should be prudent in evaluating the quality of financial reporting. Certain indicators and characteristics should be focused on to assess its quality.
Quality of Earnings Video
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