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.
- Net cash from operating activities is shown in the cash flow statement of the business.
- 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.
| 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 |
| 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.