What does earnings quality mean

Start-ups are often expected to have more net income than cash flow as they spend heavily to gain market share and make large investments that will not pay off immediately.

Investors will expect to see this difference reverse as the company matures. All accruals require a certain level of estimation, but the range of acceptable estimates and the subjectivity of those estimates can have a significant impact on earnings quality.

A change in its estimates of uncollectible accounts by two-tenths of a percent or by 20 basis points, such as from 2. This example illustrates the large impact that small changes in estimates can have on net income. In order to decrease the effect that these estimates have on earnings quality, your company can follow these best practices:.

Legitimate circumstances may arise that necessitate changes in accounting estimates. Following these best practices can help your company determine if changes are appropriate. Public companies are under intense investor scrutiny, and the pressure to increase earnings every quarter can lead companies to engage in earnings management.

Because earnings management improves reported earnings without improving economic performance, increased earnings management leads to a decrease in earnings quality.

Private equity firms, hedge funds, and other investors will likely be hesitant to invest in a company that they believe is trying to artificially inflate earnings. The Deloitte article Quality of Earnings: Focus on Integrity and Quality encourages companies to explain within their disclosures that subjectivity in estimates is caused by the nature of transactions, and not by management.

The analysis reveals issues with bad debt expense and warranty expense. Velocity Fund did not identify any other accruals that needed to be considered. A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods , rather than being earnings that are only reported as the result of a one-time event. In addition, an organization should routinely provide detailed reports regarding the sources of its earnings, and any changes in the future trends of these sources.

Another characteristic is that the reporting entity engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in the correct period, and revenues are not artificially inflated. Investors like to see high-quality earnings, since these results tend to be repeated in future periods and provide more cash flows for investors.

Thus, entities that have high-quality earnings are also more likely to have high stock prices. An increase in sales due to a marketing campaign is also a sign of the high quality of earnings. On the other hand, if the change in earnings is due to outside sources, then the company can have low-quality earnings. One can attribute low-quality earnings to the following factors;. However, in terms of quality of earnings, Company XYZ is better as its growth is due to better core operations.

Calculating earnings quality is completely subjective. Its accuracy depends on the expertise of the person or agency calculating it. Still, there is a formula to calculate it, and it is dividing the net cash from operating activities by the net income. This formula gives the quality of earnings ratio, rather than the absolute figure.

We can get the net cash from operating activities from the cash flow statement, while the net income figure is there in the income statement. If the ratio is less than one, it means net income is greater than the operating cash flows. This will suggest that the company might be using accounting techniques to inflate net income. On the other hand, if the ratio is greater than one, it would mean net income is less than the operating cash flows, suggesting a better QoE.

For investors, high-quality earnings matter more as a company is more likely to repeat such a performance in the future. That is:. There are many ways to gauge the quality of earnings by studying a company's annual report. Analysts usually start at the top of the 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 balance sheet and cash flow statement. Working down the income statement, analysts then might look for variations between operating cash flow and net income. 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. A company can manipulate popular earnings measures such as earnings per share and price-to-earnings 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 earnings-per-share growth.

When earnings-per-share goes up, the price-to-earnings ratio goes down. That should signal that the stock is undervalued. It 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 finance 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. Financial Statements. Fundamental Analysis.