What Is Quality of Earnings?

What Is Quality of Earnings?

Let me explain what quality of earnings really means for a company. It's about stripping away any anomalies, accounting tricks, or one-time events that can distort the true bottom-line performance numbers. Once you remove these, you can clearly see the earnings that come from higher sales or lower costs.

Even external factors can impact how we evaluate earnings quality. For instance, in times of high inflation, many companies' earnings quality looks poor because their sales figures get inflated too.

Generally, earnings calculated conservatively are more reliable than those using aggressive accounting policies. Earnings quality can suffer from practices that hide weak sales or heightened business risk.

Fortunately, we have generally accepted accounting principles (GAAP). The closer a company follows these standards, the higher its earnings quality tends to be.

Major financial scandals like Enron and WorldCom serve as extreme examples of poor earnings quality that deceived investors.

Key Takeaways

You need to understand that a company's true quality of earnings emerges only after spotting and eliminating anomalies, accounting tricks, or one-time events that skew the numbers. Quality of earnings represents the portion of income stemming from higher sales or lower costs. Watch out if net income rises without a matching increase in cash flow from operations—that's a red flag. A solid approach is to track from the income statement through the balance sheet and cash flow statement to assess earnings quality.

Importance of Quality of Earnings

Analysts often focus on net income as a key indicator of a company's earnings performance. If it's higher than the previous period or beats estimates, that's a positive sign for the company.

But you have to question how reliable these numbers are. With various accounting conventions, companies can tweak earnings up or down to suit their purposes.

Some companies push earnings down to cut taxes, while others inflate them to impress analysts and investors.

When companies manipulate earnings, they demonstrate poor or low earnings quality. In contrast, those that avoid manipulation show high earnings quality. As earnings quality improves, the urge to manipulate decreases, though even high-quality earners might adjust figures to minimize taxes.

As I mentioned, high-quality earnings align with GAAP standards, which prioritize reliability—meaning the metrics are verifiable, error-free, and unbiased—and relevance, where they're timely, predictive, and useful for confirming or challenging forecasts.

Analysis of Quality of Earnings

There are several methods to evaluate earnings quality by examining a company's annual report. I usually start at the top of the income statement and move downward. For example, if a company reports high sales growth, check if it's paired with high credit sales growth—analysts get cautious about sales boosted solely by lenient credit terms. You can find changes in credit sales or accounts receivable on the balance sheet and cash flow statement.

Further down, look for differences between operating cash flow and net income. If net income is high but cash flows from operations are negative, those earnings aren't coming from actual sales.

One-time adjustments to net income, like nonrecurring income or expenses, are another warning sign. For instance, a company might cut current expenses by refinancing debt into a future balloon payment, boosting this year's net income but deferring the issue.

Example of Earnings Manipulation

Companies can tamper with metrics like earnings per share (EPS) and price-to-earnings (P/E) ratio through stock buybacks, which reduce outstanding shares. This way, even with declining net income, they might show EPS growth.

When EPS rises, the P/E ratio falls, suggesting the stock is undervalued—but not if it's just from repurchasing shares.

It's especially concerning when companies borrow to fund these buybacks, artificially inflating share prices by limiting available shares and creating a false impression of increased value.

Which Earnings Calculation Is Considered More Reliable?

Conservatively calculated earnings are seen as more reliable than those from aggressive accounting. Earnings quality declines when practices conceal poor sales or elevate business risk.

What Does Quality of Earnings Say About a Company?

If a company adheres to GAAP standards, it indicates high earnings quality. Conversely, manipulation points to poor or low quality.

What Are Red Flags in Annual Company Reports?

In a company's annual report, be alert for issues like high sales driven only by loose credit terms, high net income alongside negative operational cash flows, or one-time adjustments known as nonrecurring income or expenses.

The Bottom Line

Ultimately, a company's genuine earnings quality comes to light by identifying and removing anomalies, accounting tricks, or one-time events that distort performance metrics. Once cleared, you can plainly see earnings from higher sales or lower costs.