Updated July 15, 2023
Definition of Quality of Earning
Quality of earning refers to a situation where the company or organization’s earnings increases due to an increase in sale and operational revenue, where a mere increment in earnings without an increase in operational income does not amount to quality of earnings.
This quality of earning is an important factor as on the basis of this, the investors 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 operational activities. Suppose the organization or company does not have operational income; it considers less reliable as it has no operations. It focuses more on earnings through the quality of income. If the operational revenue is strong enough, the organization can survive in the long run, 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 costs without considering the effect of inflation or accounting policy changes.
Features of Quality of Earning
The following are the features of quality of Earnings:
- Measure for Performance of Earnings: Through Quality of earnings, one can measure the actual rise in income due to an increase in operational revenue. It reports 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 it accumulates its revenue, various sources of income, etc.
- Part of due diligence: Quality of earnings 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 organization’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 the quality of income ratio. It only considers the operating cash flows. The formula for calculating the quality of Earning is as under:
Where the net cash from operating activities calculate without giving the effect of inflation, changes in accounting policies and estimates, etc.
How Does Quality of Earning Work?
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 analyst also nullifies the effect of changes in accounting policies and calculates the pure growth in sales of pure cost reduction other than technological changes or removal of labor from the job. If the company has high earnings but a negative operating cash flow, the company or organization is earning more from the other non-operating activities. The sales and expenses consider as operating in nature 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 increases 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 increased by 150%, but sales reduced to 10%, and expenses 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 rises due to non-operational activities as sales are 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 calculates after considering the depreciation of $ 5,240 and the non-operating expenditure of$ 4,070. The non-operating income includes $ 7,850.
Calculate the Quality of Earnings ratio.
Solution:
Net cash flow from operating activities calculates as
- 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 calculates using the formula given below:
- Quality of Earning = $37,260 / $35,800
- Quality of Earning = 1.04
Assessing Quality of Earning
Quality of Earning assesses in the following way:
Quality of earnings 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 is 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
The following factors are affecting 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., affect the quality of earnings and add 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 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 income quality.
Advantages
The 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.
- The quality of earnings report is the basic report on which investors make investment decisions.
- It only focuses on the real growth of the organization.
Disadvantages
The 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 complicates and differs from person to person.
- The effect of nullifying the accounting policy is almost impossible, or it requires expert involvement, which increases the organization’s cost.
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 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 the inflation effect or the effect of changes in accounting policies. For this calculation, the expert is to be hired, which ultimately increases the cost. The Report is important as it is part of the due diligence report and highly basis for investors to make investment decisions.
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