Definition
Earnings quality assesses whether earnings are sustainable, repeatable, and backed by cash flow. High-quality earnings come from recurring operations and convert to cash. Low-quality earnings may include one-time gains, aggressive accounting, or high accruals relative to cash flow.
Formula
Accruals Ratio = (Net Income - Operating Cash Flow) / Average Assets
Example
Company A has $50M net income and $55M operating cash flow (high quality). Company B has $50M income but only $30M cash flow (lower quality due to $20M accruals).
FAQ
What is Earnings Quality?
How well reported earnings reflect true economic performance.
How do you calculate Earnings Quality?
A common formula for Earnings Quality is: Accruals Ratio = (Net Income - Operating Cash Flow) / Average Assets
Why is Earnings Quality important?
Earnings Quality helps investors evaluate profitability and make more informed decisions.