Quality of Earnings

Two companies can report the same profit with very different quality. High-quality earnings are recurring, backed by cash flow and based on conservative, consistent accounting. Low-quality earnings rely on one-time gains, optimistic estimates or accounting choices that boost profits without matching cash.

Analysts assess quality by comparing net income with operating cash flow, looking for large or growing accruals, identifying one-off gains and losses, checking changes in accounting policies and estimates and examining trends in receivables and inventory relative to sales.

For example, if a company's profits rise because it sold a building, or because it extended the estimated lives of its assets to cut depreciation, its earnings quality is lower than if profits rose because of higher sales and margins.

In acquisitions, buyers often commission a quality of earnings report from accountants, which adjusts reported profits to show the sustainable earnings the business really generates.