Quality of Earnings

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 Flow Cash 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. read more, and it must be sustainable. Earnings that are “tied up” in accounts receivableIn Accounts Receivable Accounts 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. read more, 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 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 earningsEarnings Earnings 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.read more 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 Sales Credit 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. read more. Usually, analysts are not fond of loose credit policies and prefer organic growth in salesOrganic Growth In Sales Organic 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.read more. A company may have a high net income, but at the same time, negative cash flowsNegative Cash Flows Negative 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.read more from operations. This can be done through artificial means.

Indicators of Overall Earnings Quality

The financial statementsThe Financial Statements Financial 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.read more 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 Policies Accounting 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.read more
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