Quality of EarningsHow high is your business's quality of earnings?

The primary purpose of establishing a business is to earn profits.

The higher the profits, the better.

There are primarily two ways of raising profit.

One is to generate more sales.

When a business has high revenues, it’s more likely to have higher profits too.

The other way is to lower costs.

The fewer the costs that eat up a business’s revenue, the higher its profits will be too.

You can find information about a business’s net income/profit from one of its financial statements, the income statement.

But the thing is, financial statements can be “cheated”.

Several accounting tricks can be applied to make a business’s financial statements more “presentable”.

While it isn’t illegal to use these tricks, it can lead to lower quality of earnings.

Let’s say that there are two competing businesses, company AJ and company BK.

In the year 2021, company AJ was able to generate sales of $800,000, 80% of them being cash sales.

On the other hand, company BK was able to generate sales of $1,400,000, with 80% of them being credit sales.

On paper, company BK has the higher revenue, right?

But what if in reality, company BK is only able to collect 30% from its credit sales?

Sure, company BK has the higher earnings on paper, but its quality is inferior to company AJ’s.

If I’m an investor, I would invest in company AJ just because I think that they’re more consistent.

What I’m saying is, looking at a business’s income statement that shows a high level of earning can be exciting, yes.

But don’t jump the gun just yet. Consider the quality of earnings first.

It can be good on paper, but not so in reality.

It’s always better if a business’s income statement can also translate into its actual economic situation. 

What is Quality of Earnings?

Net income is a figure that investors, analysts, and even creditors give importance to.

It provides a quick view of how well the business is performing financially.

To simplify it, if a business’s net income is historically on the rise, then that means that’s it doing well.

On the other hand, if its net income is going down or fluctuating, it may mean that the business hasn’t found its footing yet

But as I’ve already mentioned, a business’s financial statements can be “cheated” to make them look better than they should be.

Due to several accounting tricks that a business can employ, it can manipulate earnings numbers up or down to make them more attractive.

The more “tricks” the business uses, the higher the dip will be in its quality of earnings.

Think of it this way.

The more accurate the net income of a business is of its economic situation, the higher is its quality of earnings.

That is to say, we can reveal a business’s quality of earnings if we remove the effects of any anomalies, accounting tricks, or one-time transactions that can affect its “real” bottom-line figure.

If the “new” figure is close to the “previous” one, then we can say that the quality of earnings is high.

However, if they’re far apart, then that’s a sign that the earnings numbers were heavily manipulated.

Quality of earnings can also refer to how repeatable, consistent, controllable, and bankable the reported earnings are.

Typically, a business earns revenue from its main operations. However, a business can also earn revenue from other sources such as the sale of a long-term asset.

These “unusual” earnings can increase a business’s net income, but they are often not repeatable.

This makes them of lower quality than the earnings from main operations.

Why Quality of Earnings is Important

Have you heard about the Enron scandal?

It is said to be the most notorious accounting scandal in American history, if not the world.

Basically, Enron was able to trick its investors into thinking that it was performing well.

But the truth is, all of its reported earnings were mostly only paper income.

When the scandal was uncovered, the value of Enron shares plummeted to $0.26, which is almost worthless.

By manipulating the financial statements to make them look better, a business can trick a potential investor into thinking that it’s doing well.

If a business’s financial statements are heavily manipulated, chances are, its earnings numbers don’t truly represent its economic condition.

Which leads to a heavy dip in the quality of earnings.

Businesses with a high quality of earnings usually follow the accounting standards, one of which is the GAAP.

The GAAP’s fundamental qualities are reliability and relevance.

Information is reliable when it is verifiable, error-free, without bias, and can accurately represent the transaction.

It is relevant when it is timely and has predictive power.

Meaning that a business can use it to confirm or contradict prior predictions as well as make new predictions.

That’s why earnings as a result of a business’s main operations are ranked higher in terms of quality than those that aren’t.

It’s easier to predict earnings from main operations than the earnings from the sale of a long-term asset.

A business is more likely to generate revenue from operations every year than from the sale of a long-term asset after all.

Of course, just having a high sales volume isn’t enough. It should also result in a positive net cash flow.

In general, cash sales are better in quality than credit sales. Cash now is better than cash later.

How to Gauge a Business’s Quality of Earnings

There are several ways to gauge a business’s quality of earnings.

One way is to study the business’s financial statement.

Usually, when one looks at a business’s income statement, s/he goes straight to the net income (the bottom-line) to see if it’s positive or not.

If it’s positive, the next step is to assess how high it is.

But to gauge its quality, one should start at the top.

Be wary of the quality of sales (cash sales vs credit sales)

For example, an income statement may show that the business has a high sales growth for the year.

Upon closer look, you see that about 90% of this growth is due to an increase in credit sales.

While this isn’t necessarily a bad thing, it could be a red flag.

Because of this, you look into the business’s balance sheet if there’s a drastic increase in accounts receivable.

Let’s assume that there is.

This could indicate that the business loosened some of its credit terms.

This could affect the collectability of these accounts.

To further investigate this matter, you can take a look at the aging of receivables.

If there’s an increase in receivables aged more than 30 days, you can say that there is a dip in the quality of earnings as a result of the increase in credit sales.

High net income usually results in positive cash flow

Aside from that, you can take a look at the income statement and cash flow statement side by side.

Having a high net income should result in a positive net cash flow.

If it’s otherwise (high net income, negative cash flow), it could mean that most of its earnings come from sources other than sales.

Or it could mean that the business was able to generate high credit sales but low receivables turnover.

Examine one-time adjustments (non-recurring income or expenses)

You can also look for one-time adjustments to net income or expenses.

While it isn’t always the case, a one-time adjustment may be the result of a change in accounting policies.

This can be a red flag if it was made to make the income statement look better than it should be.

For example, a business may decrease expenses in the current period by deferring payment through refinancing (e.g. balloon payment).

This decrease in expenses will ultimately increase net income for the current period.

This increase in net income is of poor quality as it’s the result of a one-time adjustment.