Net Income is one of the most important pieces of financial information reported by companies, often referred to simply as “earnings.” Earnings are a primary metric used to value a company which is why stock prices are very sensitive to earnings surprises. However, earnings, like most other line items on accrual-based financial statements, are just an estimate of reality. That is, earnings are calculated from multiple estimates such as bad debt expense, depreciation expense, and others which can significantly impact valuation calculations. This is why understanding the concept of “earnings quality” is valuable.
Defining Earnings Quality
It is hard to find a financial conversation without someone referring to “earnings quality,” but how exactly is earnings quality defined? Unfortunately, there is no crisp definition of earnings quality which not only makes it a vague term, but also opens the door for companies to define it differently. To add some clarity to the vagueness, earnings quality can be viewed from at least three perspectives:
First, earnings quality can refer to the persistence of net income. Earnings persistence generally refers to the stability of earnings, which is important for predicting earnings. The more stable the earnings, the more stable the stock price in an efficient market. To the extent earnings and stock prices are stable, they are more predictable, which is attractive to investors. So, from this perspective, the more stable the earnings, the higher the perceived earnings quality. It is important to note that this perspective implies that the quality of reported earnings can be considered high even if earnings are trending lower. But even in this case, if they are predictable, then risk management techniques can be deployed.
Second, earnings quality can refer to whether or not earnings are likely to be higher in the future. This is probably what most are referring to when they use the term earnings quality, but it can also be the most troublesome definition.
It is common for growth companies to report increased earnings every period, but that does not mean that the reported earnings are the most accurate estimate of the company’s underlying economic reality. Furthermore, if the company’s goal is to report earnings that are high quality earnings based on this definition, then the company has incentive to understate actual earnings to maximize the probability that earnings will be higher in the future. Again, the reported earnings would therefore depart for economic reality. Nonetheless, from this perspective, if a company’s earnings are rising period-over-period, their earnings are considered high quality.
Finally, earnings quality can refer to how closely net income on the income statement equals economic income. This is the most theoretical of the perspectives and arguably the best since the purpose of the financial statements is to most properly represent economic reality. But it requires an understanding of “economic income.”
Economic income refers to all transactions that affect a company’s value, some of which are not reported on the financial statements due to GAAP constraints. For example, depending on how marketable securities are classified, the change in value of the securities that a company owns is generally not reported on the income statement. The result is a change in the company’s value that is not included in the calculation of earnings. Since net income in this situation does not include the increase in value, earnings quality is considered to be lower.
Measuring Earnings Quality
Assuming earnings quality is defined from the second perspective, the primary concern is whether or not earnings are being artificially propped up by GAAP accounting accruals. More specifically, earnings quality is negatively impacted by income-increasing accounting accruals for the following reason:
Accruals are the result of dividing a company’s life into accounting periods and they primarily represent timing differences between these periods. Therefore, they are expected to unwind in the future. So, if earnings are higher this period merely because of accruals, then with all other things being equal, they would be expected to be lower in the future as the accruals unwind. So how can the quality of earnings be measured?
While earnings are calculated from multiple estimates of reality, cash flows are not. That is, while we can argue about the correct calculation of earnings, there is usually nothing to argue about regarding cash flow. If a company receives $100, they unquestionably received $100. This objectivity makes cash flow a useful metric for measuring earnings quality.
There are multiple calculations that can be employed, but the easiest is to simply divide net income from the income statement by the operating cash flow from the statement of cash flow. Operating cash flow rather than total cash flow should be used because accounting accruals are captured in the operating section of the statement of cash flow. Usually, net income will be less than operating cash flow primarily because of the depreciation accrual. Therefore, the higher this ratio, the lower the earnings quality especially if the result is greater than 1.00, because the relatively high earnings may be the result of accruals that will reverse in the future.
The earnings quality ratio is especially worrisome if it has been trending higher and greater than 1.00 over multiple periods.
Why Not Focus Exclusively on Cash Flow?
Since earnings are questionable due to the estimates used and cash flows are not, then it is tempting to just focus exclusively on cash flow. However, this is not optimal.
In any given accounting period, the ideal information reported on the financials is information that is both relevant and reliable. Cash flows are reliable for the reason explained above, but they can suffer from relevance due to potential timing issues. For example, if a company makes a sale in the current accounting period, the company may not receive the cash until an unknown time in the future. Focusing exclusively on cash flow would lead managers to conclude that the company added no value to the business during the period. This conclusion is clearly not correct.
Conversely, net income does not suffer from timing issues because the company’s sale will be reported as revenue in the same accounting period regardless of whether or not the cash has been collected. So, in this example, net income is more relevant than cash flow because it is reported in a timely manner, which is one of the purposes of GAAP. But it can suffer from reliability because the sale may never be collectible resulting in net income being overstated. Therefore, to assess earnings quality most accurately, neither earnings nor cash flow should be viewed in isolation. Rather, they should be analyzed together to sift out information that is both relevant and reliable.
Summary
A company’s earnings are one of the primary metrics used to value the business. Definitions of earnings quality vary, but earnings quality usually refers to whether or not earnings are expected to be higher in the future. The accounting process can put downward pressure on future earnings if current earnings are being propped up by accounting accruals. To gain a feel for this possibility, earnings quality can be estimated by comparing net income to underlying cash flow. To the extent net income is high relative to cash flow, earnings quality may be impaired.
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