What is Quality of Earnings Ratio?
The Quality of Earnings Ratio (QoE) is a profitability ratio that can determine the reliability of a company’s reported net income.
How to Calculate Quality of Earnings Ratio?
- Net Income → The net income line item—i.e. the “bottom line”—is found on a company’s income statement and represents its accrual-based accounting profits.
- Cash from Operations (CFO) → The cash from operations line item, often referred to as operating cash flow (OCF), is found on a company’s cash flow statement (CFS) and is calculated by adjusting net income for non-cash items and changes in net working capital (NWC).
The reporting guidelines set under U.S. GAAP represent the standardized methodology by which public companies located in the U.S. must abide. However, accrual accounting remains an imperfect system that is still prone to earnings manipulation, wherein a company’s net income can be misleading to the true state of its profitability.
For instance, the accrual-based net income can be misconstrued by the following accounting adjustments:
- Non-Cash Items → e.g. Depreciation and Amortization, or “D&A”)
- Non-Recurring Items → e.g. Gain or Loss on Sale, PP&E or Inventory Write-Down)
- Discretionary Management Decisions → e.g. Useful Life of Fixed Asset, FIFO vs. LIFO, Revenue Recognition Policies
The net income of a company can be artificially inflated via deceitful tactics by management intentionally, or it can also stem from accounting conventions that reflect the shortcomings of accrual accounting, rather than a deliberate attempt by management to mislead investors.
The premise of quality of earnings (QoE) reports, which are prepared by independent accountants and auditors, is that not all earnings are equal, i.e. earnings are not equal to cash flow.
Therefore, financial metrics such as the QoE ratio are used to ensure the reported net income can in fact be relied upon to evaluate the historical performance of a company, which can form the basis of a forecast model (and its implied valuation).
In practice, determining the earnings quality of a company is a time-consuming process in which detailed analysis and various techniques are necessary to truly grasp the quality of a company’s earnings profile.
Such a task is most often outsourced to an accounting firm that specializes in performing detailed diligence on a company’s earnings, but there are several “quick and dirty” approaches to estimating a company’s earnings quality.
Quality of Earnings Ratio Formula (QoE)
The formula to calculate the quality of earnings ratio (QoE) is as follows.
- Cash from Operations (CFO) = Net Income + D&A – Increase in NWC
- Net Income = Pre-Tax Income (EBT) – Taxes
What is a Good QoE Ratio?
The general rules for interpreting the quality of earnings (QoE) ratio are the following:
- QoE Ratio > 1.0x → Higher Quality Income
- QoE Ratio < 1.0x → Lower Quality Income
The practicality of the quality of earnings ratio (QoE) is that a company’s net income recorded per accrual accounting standards is separated from non-operating items that are not part of a company’s core business activities or related to accounting conventions.
A higher QoE ratio—i.e. cash from operations exceeds net income—implies that the company’s reported earnings are more reliable and not distorted by earnings manipulation.
In contrast, a lower QoE ratio indicates that the company’s cash from operations is less than its net income, meaning that more of the reported earnings are attributable to accounting adjustments, which is often a red flag with regard to corporate governance and internal policies.
Since the earnings are of higher quality, the result is a more dependable forecast model.
Quality of Earnings Ratio Calculator — Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Quality of Earnings Ratio Calculation Example
Suppose you’re tasked with calculating the quality of earnings ratio (QoE) of a company given the following set of financial assumptions for the fiscal year ending 2022.
2022 Financial Data
- Net Income = $100 million
- Depreciation and Amortization (D&A) = $20 million
- (Increase) / Decrease in NWC = ($5 million)
- (Gain) / Loss on PP&E Sale = $25 million
- Inventory Write-Down = $10 million
Since net income—the denominator in the calculation of our ratio—is provided, the only remaining steps are to reconcile net income to determine the company’s cash from operations.
Depreciation and amortization expense (D&A) is a non-cash expense, so the $20 million recorded on the income statement must be treated as an add-back since no actual movement of cash occurred.
From there, we’ll subtract the increase in net working capital of $5 million. An increase in net working capital (NWC) is an outflow of cash (i.e. “use”), whereas a decrease in net working capital (NWC) is an inflow of cash (i.e. “source”).
The next two adjustments are a $25 million loss on a PP&E sale and a $10 million inventory write-down.
- Loss on PP&E Sale → The company sold PP&E for a net loss of $25 million, which is recognized on the income statement as a non-operating expense.
- Inventory Write-Down → The fair market value (FMV) of the company’s inventory is reduced below its book value, i.e. the carrying value on the balance sheet, so the company must record a loss on the income statement.
In neither scenario, however, does the company actually incur a loss of cash in the current period. Thus, the loss on the PP&E sale and inventory write-down reduced the company’s net income on the income statement, but both items are treated as non-cash adjustments in our CFO calculation.
- Cash from Operations (CFO) = $100 million + $20 million – $5 million + $25 million + $10 million = $150 million
Once we enter our inputs into the formula from earlier, we arrive at a quality of earnings ratio of 1.5x for our hypothetical company, which implies the company’s actual earnings are understated (and of higher quality) relative to the net income recorded on its income statement.