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Quality of earnings is a term that describes how earnings are perceived or recognized. The idea is to not only account for the total amount of earnings, but understand how those earnings were realized. In general, this type of distinction can help identify whether the earnings are due to a higher volume of sales or if the earnings are due to adjustments made for inflation or as the result of some type of accounting strategy.
When the quality of earnings is due to an increase in the sales volume generated by a company that also results in an increased cash flow, the quality is identified as high quality. The same applies if the company increases profits by finding ways to reduce production costs while still maintaining the same level of production and sales volume. In both scenarios, the company is able to improve its bottom line, and thus is stronger from a financial point of view.
The quality of earnings can also reflect situations where some type of outside factor has influenced the nature of the company’s earnings. Changes in the general economy is one of the most common factors that relates to this aspect of qualifying the nature of the earnings. In particular, the rate of inflation will have some impact, in that while inflation may drive up the prices for each unit sold, there is a good chance that the actual number of units sold will decrease. This can create a perception where the company appears to be earning more, when in fact it is having to absorb higher production costs and selling fewer units.
Accounting methods can also impact the quality of earnings. Using generally accepted accounting principles, it is possible to sometimes enhance the positive aspects of the cash flow situation, creating a perception that the company is in better financial condition than it really is. This is sometimes managed by understating cash flow during good years, and reserving that extra to apply during a year when sales are off. While legal in many parts of the world, this type of cookie jar accounting can be somewhat misleading to investors, and thus create unrealistic hopes for the future performance of the business.
Understanding the nature of the quality of earnings can help companies have a better picture of their true fiscal worth. In a situation where the company shows apparently strong earnings, there is a good chance that the shares of stock issued by the company will increase in value. If that strength is due to increased sales or decreases in production costs, the price increase of the stock is justified. Should the strong earnings be due to inflation or even to some type of accounting process, the stocks may be overvalued, a situation that can lead to problems for the business at some future point.
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