Quality of earnings is an accounting term that refers to the ability of previous earnings—the net income from previous years—to predict the business’ future cash flow.
When it comes to finance, not all earnings are equal, and earning a lot of money is not equal to having good cash flow.
Quality of earnings is considered a safer, more conservative metric to evaluate a company’s financial health, rather than the net income. Quality of earnings is also called earnings quality.
Quality of earnings ratio
You can work out the quality of earnings ratio, by taking the net income—the bottom line that’s found on the company’s income statement—and dividing it by cash from operations.
Cash from operations, also called operating cash flow, is found on the cash flow statement. It’s net income minus non-cash items.
If the quality of earnings ratio is above 1, it’s considered high quality income. It means that cash from operations exceeds the net income, and implies that the company’s reported earnings are reliable.
If the ratio is below 1, it’s considered a low quality income. It means that the net income exceeds the cash from operations, in other words: A lot of what the company earns comes from accounting adjustments, not from the sale of goods and services.
Of course, many things go into evaluating the quality of earnings, and it’s usually done by accountants and auditors who specialize in this kind of evaluation.
An earnings quality report
When a company buys another company, the buyer will sometimes compile a quality of earnings report. The report looks at how the company that’s being sold earns money. It might have a large income, but overall a negative cash flow. Or the large income might be a one-off, that’s not likely to occur again in future.
The quality of earnings report is not an audit, although it’s performed by an auditor or an independent accountant, it’s merely a recommendation given based on the company’s history.