What is ‘Quality Of Earnings’
The quality of earnings refers to the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies.
Explaining ‘Quality Of Earnings’
One measure of fundamental analysis that analyst like to track is net income. It provides an overview of how well the company is doing from an earnings perspective. If net income is higher than it was last year and/or beats analyst estimates, it represents a win for the company, but how reliable are these earnings? Due to myriad accounting conventions, companies can manipulate earnings to serve their own needs. Some companies seek to manipulate earnings down to pay lower taxes, while others find ways to artificially inflate earnings, especially in times of earnings decline. Companies that manipulate earnings are said to have poor or low earnings quality, conversely, companies that do not manipulate earnings have a high quality of earnings.
How To Gauge The Quality of Earnings
There are many ways to gauge the quality of earnings. Start with the top of the income statement, which can be found in the annual report, and work down. Companies with high or growing sales may also have high growth in credit sales. Changes in credit sales or accounts receivable can be found on the cash flow statement. Analysts don’t like sales growth due to a loosening of credit terms. Working down the income statement, analysts also look for variations between cash flow and net income. A company that has a high net income and negative cash flows from operations may be achieving earnings through artificial means. One-time adjustments to net income, also known as non-recurring expense, are also a red flag. It is not unusual for companies to make supposedly one-time adjustments for several quarters and years in a row.
Quality of Earnings Measures
It should also be noted that companies can manipulate popular earnings measures such as earnings per share and price to earnings ratio by buying back shares of 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. Since earnings go up, the price-to-earnings ratio goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It is particularly concerning when companies take on additional debt to finance stock repurchases.
Factors that can affect quality of earnings
Companies report their earnings each quarter, and the quality of those earnings can have a big impact on the stock price. There are a number of factors that can affect the quality of earnings, including accounting methods, one-time items, and discretionary expenses. Accounting methods can have a big impact on reported earnings. For example, if a company uses accelerated depreciation, it will report lower profits in the early years but higher profits in the later years.
One-time items can also distort reported earnings. Items such as asset sales or litigation settlements can boost profits in one quarter but have no impact in future quarters. Finally, discretionary expenses such as advertising and research and development can fluctuate from quarter to quarter, making it difficult to compare earnings across time periods. Understanding how these factors can affect reported earnings is essential for making informed investment decisions.
How to improve your company’s quality of earnings
There are a number of ways to improve the quality of your company’s earnings. One is to focus on selling higher-margin products and services. This will increase the percentage of revenue that falls to the bottom line. Another way to improve earnings quality is to tightly control expenses. This can be done through efficient operations and strict cost management. Finally, you can also increase earnings by growing the top line, through increased sales and market share gains. By taking these steps, you can improve the quality of your company’s earnings and make it more attractive to investors.
The benefits of improving your company’s quality of earnings
There are many benefits to improving your company’s quality of earnings. Perhaps most importantly, it can help to attract and retain investors. When investors see that a company’s reported profits are linked to genuine underlying economic activity, they are more likely to want to put their money into the company. It can also make it easier for a company to secure loans and other forms of financing.
Lenders are more likely to extend credit when they see that a company is reporting sustainable profits. In addition, improving quality of earnings can help to build trust with employees and customers. Employees want to work for a financially sound company, and customers want to do business with a company that is on solid footing. By ensuring that its reported profits reflect underlying economic reality, a company can instill confidence in all its stakeholders.
