Quality of Earnings Ratio

The quality of earnings ratio is an indicator of the degree to which the net income of a business satisfies quality criteria. Quality is a subjective matter but generally earnings are considered to be of high quality if they have some of the following characteristics.

  • Consistent, predictable and sustainable
  • Exclude special and non-recurring items
  • Derived from the application of conservative and relevant accounting policies
  • Backed by cash operating flows

 

How to Calculate the Quality of Earnings Ratio

The quality of earnings ratio, sometimes referred to as the quality of income ratio, is calculated by dividing the net cash provided by operating activities by the net income of the business.

The formula for calculating the quality of earnings ratio is as follows.
Quality of earnings ratio = Net cash from operating activities / Net income
  1. Net cash from operating activities is shown in the cash flow statement of the business.
  2. Net income is shown in the income statement.

 

A quality of earnings significantly less than 1 indicates that the net income is greater than the operating cash flow of the business. The suggestion is that the business might be using accounting techniques to accelerate the recognition of income.

A quality of earnings significantly greater than 1 indicates that the net income is less than the operating cash flow of the business and suggests that the business is conservative in its approach to income recognition.

Earnings Quality Ratio Example

Suppose a business has the following income statement and cash flow statement for its current financial year.

Income Statement
Revenue 200,000
Cost of goods sold 90,000
Gross profit 110,000
Operating expenses 50,000
Depreciation 13,280
Operating income 46,720
Finance costs 1,756
Income before tax 44,964
Income tax expense 8,993
Net income 35,971
Cash Flow Statement
Net income 35,971
Add back depreciation 13,280
Working capital -8,429
Operating activities 40,822
Capital expenditure -20,000
Investing activities -20,000
Proceeds from long-term debt 20,000
Debt repayments -16,426
Financing activities 3,574
Net cash flow 24,396
Beginning cash balance 7,556
Ending cash balance 31,952

In the example above the net income is 35,971 and the cash flow from operating activities is 40,822. The quality of earnings ratio equation is used to calculate the ratio as follows.

Net income = 35,971
Cash flow from operating activities = 40,822
Quality of earnings ratio = Cash flow from operating activities / Net income
Quality of earnings ratio = 40,822 / 35,971 = 1.13

Real Life Quality of Earnings Ratio Analysis Using Apple Inc.

Similar calculations can be made using any published sets of financial information. For example using the financial statements of Apple Inc. for 2016 the cash flow ratio can be calculated as follows.

Net income = 45,687
Cash flow from operating activities = 65,824
Quality of earnings ratio = Cash flow from operating activities / Net income
Quality of earnings ratio = 65,824 / 45,687 = 1.44

Quality of Earnings Ratio Summary

The earnings ratio is one indicator of the quality of the net income of a business. A low ratio is not necessarily an indicator of anything improper in the preparation and presentation of the financial statements only that the net income is not supported by a corresponding operating cash flow.

If the ratio is low further investigation might be worthwhile to understand the reasons to ensure it is not due something irregular such as, for example, improper recognition of revenue, inappropriate capitalization of operating expenses, or a failure to report all liabilities.

Quality of Earnings Ratio November 10th, 2017Team

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