Quality of Earnings
Quality of earnings is a concept that judges whether accounting principles and methods selected by management lead to conservative estimates of earnings or inflated earnings. It refers to the percentage of earnings that comes from increased sales or lowered costs as opposed to one-time anomalies or income manipulation. In general, earnings that are counted conservatively using GAAP (Generally Accepted Accounting Principles) guidelines are considered more reliable than those arrived at through aggressive accounting that attempts to artificially inflate earnings to look more substantial than they actually are.
Quality of Earnings Meaning in Finance
Analysts looking to determine a company’s quality of earnings start with the income statement. They look for discrepancies between the operational cash flow and stated net income. For example, if a company reports an increase in income but a decrease in operating cash flow, it means the gain in income came from something other than improved performance and could be misleading to investors. Likewise, analysts also look for how many nonrecurring sources of income and expenses a company reports. Too many of either could indicate that the current stated net income is not representative of long-term performance and risk.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.