What is “Earnings Quality”?
Earnings quality is a measure of how reliable a company’s earnings are for assessing a company’s current and future performance. High earnings quality would usually suggest that the earnings are free from manipulation by management and a good predictor of future earnings/cash flows that will be generated by the company.
Earnings quality can be measured using several techniques and metrics; there is no single formula to assess quality. However, earnings quality analysis often includes detailed financial statement analysis to identify non-recurring items of income and expense, significant non-cash items of income and expense, and a review of balance sheet items that are dependent on management estimates.
Some of the most widely used metrics used to assess earnings quality include the cash conversion ratio and the accruals ratio. The cash conversion ratio is the amount of cash flow generated each year relative to each dollar of earnings. The accruals ratio is the total accruals in the balance sheet relative to total operating assets. A low cash conversion ratio and a high accruals ratio is an indicator of low earnings quality whilst a high cash conversion ratio and a low accruals ratio is an indicator of high earnings quality.
Key Learning Points
- Earnings quality is used to determine whether a company’s earnings provide a reliable measure of a company’s current performance and are a good predictor of future performance
- There is no single measure of earnings quality, but the cash conversion ratio and the accruals ratio are widely used metrics. A high cash conversion and a low accruals ratio are indicators of high earnings quality and vice versa
- Earnings quality drives expectations of future cash flow. It is, therefore, a key technique in credit analysis, deal due diligence (M&A and LBOs), and investment research
- Low earnings quality can provide evidence of earnings manipulation by management. It may therefore be used in corporate governance analysis
How is Earnings Quality measured?
There is no single way to assess earnings quality, but it often involves scrutiny of the financial statements to identify the following items which could impact predictions of future earnings and cash flows:
- Non-recurring items of income and expense, such as impairment charges or profits from asset disposals
- Non-cash items of income and expense, such as asset revaluations or provision releases
- Items that are dependent on management estimates, such as inventory valuation or accrued expenditure
In addition to the above, the following metrics can be used as quantitative measures of earnings quality:
Cash conversion = operating cash flow/EBITDA
Accruals Ratio = Net income – Operating cash flow – Investing cash flow/Average(Total assets – Cash & equivalents)
Why is Earnings Quality important?
Earnings quality drives expectations of future earnings and cash flows; low earnings quality will generally result in lower expectations of future earnings and cash flows relative to current earnings. This will impact estimates of debt capacity and company valuation.
Earning quality assessment, therefore, plays a critical role in several areas of financial analysis, including:
- Credit analysis for deal structuring or lending decisions
- Deal diligence for M&A, LBOs and IPOs
- Equity valuation for equity research and bond valuation for credit research
In addition to this, if earnings quality assessment provides evidence that earnings are being manipulated by management, this will raise corporate governance concerns. Therefore, earnings quality can be used as an input in corporate governance analysis.
Below extract from the financial statements for two peer companies. Company A is the established market leader in the industry whilst Company B is a smaller, high-growth competitor.
Using the information given, we have been asked to calculate the cash conversion ratio and the accruals ratio for Company A and Company B and compare their earnings quality.
We start by calculating the cash conversion ratio for both companies and immediately see that Company B has a much lower cash conversion ratio than Company A:
To calculate the accruals ratio for both companies, we first need to calculate the numerator (net income less operating and investing cash flow) and the denominator (average of total assets less cash & equivalents).
We then calculate the accruals ratio and can see that Company B has a much higher accruals ratio than Company A:
Company B has a lower cash conversion ratio and higher accruals ratio than Company A. This suggests that Company B has lower earnings quality than Company A.
But why might this be a concern to an analyst? If you review the cash flow statement extracts, you can see this is because Company B’s working capital demand is higher than Company A’s, despite Company B being a smaller company. Although this can simply be a result of Company B’s rapid growth, it could raise concerns about deteriorating business performance. For example, it could indicate reduced discipline about the collection of receivables, increased obsolescence of inventory, or that suppliers are tightening their payment terms due to credit concerns.
Download the accompanying excel files to practice these exercises for yourself.