What is the quality of earnings’
Quality of earnings refers to the amount of earnings by increasing sales and reducing costs, rather than artificial profits created by accounting anomalies or tricks, for example, the increase in stocks or change in depreciation or inventory methodology. The quality of earnings is considered poor during periods of high inflation. In addition, earnings that are calculated conservatively are considered to have higher quality than those designed for aggressive accounting policies. The quality of earnings can also be weakened due to the managers who carry out shady accounting practices to hide poor sales or increased business risk. Financial analysts often carefully assess the quality of earnings and not just take the financial statements at their nominal value.
Penetration of income
One of the indicators of fundamental analysis, Analytics how to track is net income. It provides an overview of how well the company is doing from the point of view of earnings. If net income is higher than last year and/or bumps according to analysts, it represents a victory for the company, but how reliable are these earnings? Because of the many conventions in the field of accounting, companies can manipulate earnings for their own needs. Some companies tend to manipulate earnings downwards in order to pay less taxes, while others find ways to artificially inflate profit, especially in a period of declining revenues. Companies that manipulate earnings, as they say, a bad or low quality of earnings; conversely, companies that do not manipulate income to have high quality earnings.
How to assess the quality of earnings
There are many ways to assess the quality of earnings. Starting from the top of the report on profits and losses, which can be found in the annual report of the company, analysts can work your way down. For example, companies with high and growing sales may also have high growth of sales on credit. Such changes in the volume of credit sales or receivables, can be found in the statement of cash flows. Analysts don’t like sales growth due to the weakening credit conditions and prefer to increase sales organically arise. Work statement of profit and loss, analysts can look for differences between operating cash flow and net profit. The company, which has a high net income, but has negative cash flows from operating activities can be achieve these obvious earnings through artificial means. One-time adjustments net income, also known as one-time costs, are also potential red flag is not uncommon for companies to make the supposedly one-time adjustments over several quarters and years.
Quality measures earnings
It should also be noted that companies can manipulate popular manufacturers, such as earnings per share and price-the ratio of income from the redemption of shares that reduces the number of shares outstanding. Thus, the company net profit decline could post earnings per share growth. Because revenues go up, the price-yield goes down as well, signaling that the stock is undervalued or for sale. In fact, the company just repurchased shares. This is especially true when companies take on additional debt to Fund share buybacks. Several accounting scandals such as enron and worldcom was a product of low quality earnings, which misled investors.