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 sales or lower costs can be seen clearly.

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

In general, earnings that are calculated conservatively are considered more reliable than those calculated by aggressive accounting policies. Quality of earnings can be eroded by accounting practices that hide poor sales or increased business risk.

Fortunately, there are generally accepted accounting principles (GAAP). The more closely a company sticks to those standards, the higher its quality of earnings is likely to be.

Several major financial scandals, including Enron and Worldcom, have been extreme examples of poor earnings quality that misled investors.

A company’s real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew the numbers. Quality of earnings is the percentage of income that is due to higher sales or lower costs. An increase in net income without a corresponding increase in cash flow from operations is a red flag.

Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earnings.

One number that analysts like to track is net income. It provides a point of reference for how well the company 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 accounting conventions, companies can manipulate earnings numbers up or down to serve their own needs. Some companies manipulate earnings downward to reduce the taxes they owe. Others find ways to artificially inflate earnings to make them look better to analysts 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, companies with a high quality of earnings stick with the GAAP standards. The fundamental qualities of those standards are reliability and relevance.

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