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 the quality of earnings.