Quality of earnings
Quality of earnings describe how much investor or company earns in real, excluding impact of inflation or inventory. High quality of earnings is associated with increasing sales or decreasing costs - sources of real earnings. Low quality of earnings is associated with sources like: inflation, creative bookkeeping, etc.
Companies are able to manipulate their earnings in order to make an impression of certain state of the company. They can artificially inflate earnings, move them between periods, pay lower taxes, etc. That is known as low quality of earnings.
How to measure quality of earnings?
Popular earnings measures, like earnings per share can be manipulated. Therefore deepened analysis is required. High sales should be compared with credit sales and accounts receivable (cash flow). High net income should be compared with cash flow from operations. High non-recurring expenses should be checked as they can be a signal of manipulations.
- Penman, S. H., & Zhang, X. J. (2002). 'Accounting conservatism, the quality of earnings, and stock returns. The accounting review, 77(2), 237-264.
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