The term quality of earnings ratio refers to a metric that allows analysts to understand if the earnings reported by a company are due to operational performance or accounting adjustments. The quality of earnings ratio compares reported earnings to cash flow from operations.
Quality of Earnings Ratio (%) = ((Earnings - Cash Flow from Operations) / Average Assets) x 100
Operating performance measures allow the investor-analyst to understand how well a company is performing with respect to sales, margins, and profits. One of the ways to measure the effectiveness of a company's core business is by calculating their quality of earnings ratio.
One of the most important measures of a company's performance is their reported earnings. Unfortunately, there are a number of tactics companies can take and still remain in compliance with Generally Accepted Accounting Principles (GAPP) that can mask actual operational performance. Analysts can calculate the company's quality of earnings ratio to determine if the company is using one of these tactics.
This ratio compares the company's earnings to its cash flow results and normalizes the data by the company's average assets. Ideally, the calculated ratio should be 5% or less. As this value approaches 20% or higher, the quality of earning should be very suspect.
Company ABC's most recent annual report indicated earnings of $5,000,000 and cash from operations of $4,000,000. The company's balance sheet indicated $8,500,000 in assets at the beginning of the current accounting period and $9,500,000 in assets at the end of the period. The company's quality of earnings ratio would be:
= (($5,000,000 - $4,000,000) / ($8,500,000 + $9,500,000) / 2) x 100
= ($1,000,000 / $9,000,000) x 100, or 11.1%
Based on the above analysis, Company ABC's earnings are suspect and the analyst should take a closer look at the company's report to better understand if the management team was leveraging an accounting tactic to bolster earnings.