Quality of Earning

Definition of Quality of Earning

Quality of earning refers to a situation where the companies or organization’s earnings increases due to an increase in sale and operational revenue where mere increment in earnings without an increase in operational income does not amount to quality of earnings and this quality of earning is the important factor as on the basis of this, the investor’s decide whether to invest in the company or not and how much to invest, etc.

Explanation

Quality of Earning refers to the increment in earnings due to its operational activities. Suppose the organization or company does not have operational income; it is considered less reliable as it does not have any operations. It focuses more on earnings through the quality of income as if the operational revenue is strong enough, then the organization can survive in the long run also, and non-operational income is just a bonus point. There should be a balance in operational and non-operational income to maintain the quality of earnings and gain the faith and confidence of the stakeholders. Quality of earning is an increase in the percentage of income due to higher sales or lower cost without considering the effect of inflation or accounting policy changes.

Features of Quality of Earning

Following are the features of quality of Earnings:

• Measure for Performance of earning: Through Quality of earning one can measure the actual rise in income due to an increase in operational revenue. It provides a report on how the company is performing well from an earnings perspective.
• Focus more on operational revenue: Quality of earnings focuses more on the operational revenue and income without the effect of accounting policies and non-operational activities.
• Performance measurement of revenue accumulation: Quality of earnings measures a company’s performance about how the company accumulates its revenue, various sources of income, etc.
• Part of due diligence: Quality of earning is part of the due diligence report prepared by an independent third party. Hence it is more reliable.

The formula for Quality of Earnings

Quality of earning is the percentage of net earnings from operating activities to the organisation’s net total income to measure the company’s operating income and performance from its operating activities. The quality of earnings ratio is also called as the quality of income ratio. It only considers the operating cash flows. The formula for calculating the quality of Earning is as under:

Quality of Earning = Net Cash from Operating Activities / Net Income

Where the net cash from operating activities is calculated without giving the effect of inflation, changes in accounting policies and estimates, etc.

How Does Quality of Earning Works?

Quality of earning works in the following way:

The analyst prepares the report by analyzing the income statement starting from sales. Evaluate the increase in sales, evaluate the inflation effect, and reduce the sales’ inflation effect. The analyst also evaluates whether there is a change in credit terms due to which sales increase, and accordingly, all the effects other than pure operational in nature are nullified. The effect of changes in accounting policies is also nullified by the analyst and calculate the pure growth in sales of pure reduction of cost other than technological changes or removal of labour from the job. If the company has high earnings but a negative operating cash flow, it shows that the company or organization is earning more from the other non-operating activities. Both the sales and expenses are to be considered operating in nature so as to calculate the appropriate ratio.

Examples of Quality of Earning

An example of Quality of Earnings is as under:

Example #1

Company ABC’s net income is increased by 50 percent from last year. The annual Inflation rate was 7 %. The sales increased by 100 % without any changes in credit terms. The operating expenses were almost the same as last year, whereas the company’s MNP’s net income is increased by 150%, but sales reduced to 10%, and expenses also increased by 15%. Determine which company has a better quality of earnings?

Solution:

Calculation of net increase in the operating income ratio of Company ABC: 50 % – 7 % = 43 %.

Whereas in the case of company MNP the income raised due to non-operational activities as sales is reduced. Hence the company ABC has more and higher quality of income.

Example #2

There is a company ABC ltd whose Net income for the year is $35,800 and the sales of $20,000 where payment against all sales is received, and no amount is pending. This income is calculated after considering the depreciation of $ 5,240 and non-operating expenditure of$ 4,070. The non-operating income includes $ 7,850.

Calculate Quality of Earnings ratio?

Solution:

Net cash flow from operating activities is calculated as

Net Cash Flow from Operating Activities = Net Income + Depreciation + Non-Operating Expense – Non-Operating Income

• Net cash flow from operating activities = $35,800 + $5,240 + $4,070 – $7,850
• Net cash flow from operating activities = $37,260

Quality of Earning is calculated using the formula given below:

Quality of Earning = Net Income or Cash Flow from Operating Activities / Net Income

• Quality of Earning = $37,260 / $35,800
• Quality of Earning = 1.04

Assessing Quality of Earning

Quality of Earning is assessed in the following way:

Quality of earning is assessed by removing the effect of non-operating and non-cash activities. like if the net income is calculated after writing off depreciation or amortization or obsolescence of inventory, the effect of all the items are to be added back to the income and similarly, the effect of non-operating income like interest income, dividend, income from investments are to be reduced.

Factors Affecting Quality of Earnings

Following factors are affecting to the quality of earnings:

• Non-Operating Expenses: Non-operating expenses like interest paid on a personal loan, onetime expenses like purchase of small equipment, repairs to machinery which are non-regular in nature etc., affects the quality of earnings and to be added back.
• Inflation and Changes in Credit Terms: The inflation effect is to be reduced from the sales or net income, and if there are changes in credit terms due to which the sales are increased, the effect of the same is also to be reduced.
• Non-Cash Expenses: Non-cash expenses like depreciation on assets, amortization of assets etc., are to be added back to calculate the effective quality of income.

Advantages

Following are the advantages of Quality of income:

• It measures the actual growth of the company or organization due to operational activities.
• The quality of income report is part of the due diligence report and prepared by an independent third party.
• Quality of earnings report is the basic report on which investors takes the investment decisions.
• It only focuses on the real growth of the organization.

Disadvantages

Following are the disadvantages of Quality of income:

• Calculation of Net Operating income is a difficult task.
• It is practically impossible to nullify the effect of inflation.
• The Calculation part is complicated and differs from person to person.
• The effect of nullifying the accounting policy is almost impossible, or it requires expert involvement, which increases the cost of the organization.

Conclusion

Quality of Earning is the ratio of net operating income to the net income to calculate the company’s actual growth due to operational activities. it basically focuses on operational growth as non-operational income may or may not last in the future. But it becomes impossible to nullify the effect of non-operational items like inflation effect or effect of changes in accounting policies, and for this calculation, the expert is to be hired and which ultimately results in an increase in the cost. The Report is important as it is part of the due diligence report and highly basis for investors to make investment decisions.

Recommended Articles

This is a guide to Quality of Earning. Here we also discuss the definition and how does quality of earning works? along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Appropriate Retained Earnings
2. Fixed Income Trader
3. Earned Income
4. Accrued Income