What Is Quality of Earnings?

A company’s quality of earnings is revealed by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. Once these are removed, the earnings that are derived from higher saleꦫs or lower c☂osts can be seen clearly.

Even factors external to the company can affect an evaluation of the quality of earnings. For example, during perio🦩ds of high inflation, quality of earnings is considered poor for many or moꩲst companies. Their sales figures are inflated, too.

In general, earnings that are calculated conservatively are considered more reliable than those calculated by 澳洲幸运5开奖号码历史查询:aggressive accounting policies. Quality of earnings can be eroded by accounting practices that hide poor sales or increased 澳洲幸运5开奖号码历史查询:business risk.

Fortunately, there are 澳洲幸运5开奖号码历史查询:generally accepted accounti🐓ng prin🌟ciples (GAAP). The more closely a company sti𝐆cks to those standards, the higher its quality of earnings is likely to be.

Several major financial scandals, including Enron and WorldCom, have be💫en extreme examples of poo⭕r earnings quality that misled investors.

Importance of Quality of Earnings

One number that analysts like to track is 澳洲幸运5开奖号码历史查询:net income. It provides a point of reference for how well the com🐭pany is doing from an earnings perspective. If net income is higher than it was the previous quarter or year, and if it ♋beats analyst estimates, it’s a win for the company.

But how reliable are these earnings numbers? Due to the myriad of 澳洲幸运5开奖号码历史查询:accounting conventions, companies c♊an 💫manipulate earnings numbers up or down to serve their own needs.

Some companies manipulate earnings downwa🌞rd to reduce the taxes they owe. Others find ways to artificially inflate earnings to make them look better to ana🌃lysts and investors.

Companies that manipulate their earnings are said to have poor or low earnings quality. Companies that do not manipulate their earnings have a high quality of earnings. This is because as a company’s quality of earnings improves, its need to manipulate earnings to portray a certain financial state decreases. However, many companies with high earnings quality will still♉ adjust their financial information to minimize their tax burden.

As noted above, companie𓃲s with high quality of earnings stick with the GAAP standards. The fundamental qualit𒊎ies of those standards are reliability and relevance. That is:

• Reliability: The metric is verifiable, free from error or bias, and accurately represents the transaction.
• Relevance: The metric is timely and has predictive power. It can confirm or contradict prior predictions and has value when making new predictions.

Analysis of Quality of Earnings

There are many ♏ways to gauge theꦍ quality of earnings by studying a company’s annual report.

Analysts usually start at the top of the 澳洲幸运5开奖号码历史查询:income statement and work their way down. For instance, companies that report high sales growth may also show high growth in credit sales. Analysts are wary of sales that are due only to loose credit terms. (Changes in credit sales, or accounts receivable, can be found on the 澳洲幸运5开奖号码历史查询:balance sheet and 澳洲幸运5开奖号码历史查询:cash flow statement.)

Working down the income statement, analysts then might look for variations between operating 澳洲幸运5开奖号码历史查询:cash flow and net in꧑come. A company that has a high net income🎶 but negative cash flows from operations is achieving those apparent earnings somewhere other than sales.

One-time adjustments to net income, also known as nonrecurring income or expenses, are another red flag. For example, a company may decrease expenses in the current year by refinancing all of its debt into a🐼 future balloon payment. This would lower debt expense and increase net income for the current year while pushing the repayment problem down the road. Naturally, long-term investors don’t care for that move.

Example of Earnings Manipulation

A company can manipulate popular earnings measures such as 澳洲幸运5开奖号码历史查询:earnings per share (EPS) and 澳洲幸运5开奖号码历史查询:price-to-earnings (P/E) ratio by buying back shares💎 of its own stock, which reduces the number of shares outstanding. In this way, a company with declining net income may be able to post EPS growth.

When earnings per share go up, the price-to-earnings ratio goes down. This should signal that the stock is 澳洲幸运5开奖号码历史查询:undervalued. Itಌ doesn’t, though, if the company changed the number by simply repurchasing shares.

It is particularly worrisome when a company takes on additional debt to fin♉ance stock repurchases. Companies might do this to artificially inflate the per-share price of their stock by reducing the number of shares available for purchase on the open market, thus giving the impression that the value of the stock has increased.

The Bottom Line

A company’s real quality of earnings is revealed by spotting and removing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. After they are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.