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What Is Quality of Earnings
Quality of earnings is an accounting concept that refers to the quality of a company’s sources of revenues where earnings from core business activities are considered to be of high quality.
Companies may generate revenues from different sources in a given year.
If the revenues come from the company’s core business operations or through cost-cutting activities relating to its core business, the quality of the hearings will be high.
On the other hand, if the company’s earnings are increased due to a change in accounting rules or aggressive accounting, the quality of the earnings will be low.
Companies that are able to increase their revenues by focusing on their most profitable products and services and streamlining the way they do things to cut costs will produce the highest quality of earnings.
For example, a software development company generating more revenues through the sale or licensing of its software products will have a higher revenue quality than a company that changes how it recognizes its revenues or expenses generating paper profits.
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What Is Quality of Earnings Important
Companies with a higher quality of earnings tend to have higher stock prices and have better credibility in the market when it comes to their financial reporting.
The reason is quite simple.
A company generating revenues from its core business operations will have a better chance of generating revenues the year after, and after that, and so on.
Conversely, a company generating high revenues in a given period but mainly due to a one-time event will not have the ability to consistently generate cash flows over time.
Since the stock price represents the amount an investor is willing to pay to purchase a share of a business, companies that have the potential of generating cash flows over the long term are more valuable.
In addition, companies with higher earnings quality have a better reputation in the market when it comes to their financial reporting.
The idea is that the company uses conservative accounting practices to report its financial position.
For instance, a company using GAAP standards will have more reliable and relevant financial reports.
Reliability refers to the fact that the company has verified its numbers and can attest that they are free from bias or errors.
Relevance refers to how timely is the company’s financial reports allowing investors to make better predictions about the company’s future.
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Quality of Earnings Characteristics
The quality of earnings will have two main characteristics: revenues coming from core business operations and the reliability of a company’s financial reporting.
The first characteristic of the quality of earnings is that earnings with high quality tend to be repeatable over time.
For instance, revenues coming from a company’s core business operations will be repeatable and sustainable long-term.
This is the case as the company continues to invest in generating profits from its main area of focus.
Another important characteristic of companies having high-quality earnings is that they do not use aggressive accounting practices to report their income.
Consequently, companies with high-quality earnings are conservative in how they report their earnings and expenses and ensure that they fully recognize their revenues and expenses during the right periods.
This type of accounting practice allows investors to have a better appreciation of the company’s true financial performance and health.
On the other hand, companies using aggressive accounting practices may not adequately report their earnings and expenses during the right period or use accounting tricks to inflate or deflate various figures.
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Quality of Earnings Ratio
The quality of earnings ratio is a measure that analysts use to assess the quality of a company’s reported earnings.
The idea is to see what is the proportion of the company’s earnings coming from operational performance rather than accounting adjustments.
You can calculate the quality of earnings ratio by using the following formula:
Quality of Earnings Ratio = [(Earnings – Cash Flow From Operations) / Average Assets] X 100
With this formula, you take the company’s overall earnings and deduct the cash flow it generated from its operations.
The result divided by its average assets multiplied by 100 will give you the percentage of the company’s quality of earnings.
The lower the company’s quality of ratio, it may be a red flag to assess how the company is generating its revenues or how it is using accounting tactics to bolster its earnings.
The higher the ratio, the quality of the company’s earnings is higher as the company generates most of its revenues from its operations.
Examples of Quality of Earnings
Let’s look at a few examples of quality of earnings to see how analysts or investors may assess a company’s financial position.
To start with, a company with high-quality earnings is a company that has solid income from its core operations and uses conservative accounting practices.
Example 1
Imagine a company generates $10 million from its core operations and $50 million from the sale of property this year.
The company will report $60 million in revenues.
Although the company’s revenues are high, the quality of the $10 million is higher than the $50 million as it’s recurring whereas the other is a one-time event.
Example 2
Another example is a company using accounting tricks to manipulate figures.
For instance, a company may artificially inflate its net income by making nonrecurring income or expense adjustments to its income statement.
For instance, a company may refinance the debt payable this year pushing it off to a future period.
A company may also show higher sales by loosening up its credit terms.
Although the company may generate more sales, it may end up having to deal with unrecoverable accounts and bad debt in the future.
Example 3
A company can manipulate its earnings by lowering its capitalization limit.
This way, the company can reclassify assets as fixed assets allowing it to defer the expenses to the future when depreciation is recognized.
This practice will allow companies to increase their short-term profits through simple accounting manipulation.
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Takeaways
So there you have it folks!
What does quality of earnings mean?
In a nutshell, the quality of earnings refers to the reliability of a company’s financial performance and the generation of revenues from core business areas of activity.
This means that we can nuance the quality of earnings in two ways.
The first feature is that the revenue should come from business operations where the company has a core focus, the revenue will be repeatable, and long-term.
The second feature is that the company uses conservative accounting practices to report its financial performance thereby increasing the reliability of its financial reports.
In essence, quality of earnings is to measure a company’s cash flow and that can be generated over time and accounting practices.
Now that you know what the quality of earnings means and why it’s important, good luck with your research!
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