Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

Ratios: Quality of Earnings Ratio



Ratios: Quality of Earnings Ratio and Earnings Management

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Alright, let's discuss another concept here. Quality of earnings. And let's start with the quality of earnings ratio. So the quality of earnings ratio? It's gonna measure we're gonna compare our incoming cash flows from operations with net income? Okay, so this is gonna be kind of interesting because remember cash flow and income, they don't always align with each other. Okay, So quality of earnings, it's a common profitability ratio. Okay. We're analyzing the profitability of the company, not just from an income perspective, but from a cash perspective. So remember that income and cash flow are not directly aligned, always in a cruel accounting. So we're doing accrual accounting here. And like we've seen sometimes when we book revenues, it's not necessarily that we received the cash right away. Right? We booked the revenue when we provide the service to the customer, even if they haven't paid us for it. So when we've done our end of the bargain for the customer, we're gonna take the revenue even if we haven't gotten the cash. So in this case we might make a journal entry like accounts receivable, right? Because they're gonna pay us later and then we're gonna credit revenue. Right? So we're taking revenue in the current period even though we haven't received the cash from that revenue. Okay, So this could be a problem. Right. What if we never received that cash if we're booking all these revenues were like here, Yeah. Buy our product, take our product, you can pay us later. You can pay us later. It's all good, We're booking all this revenue? Great. But what if we never see that cash, Right? What if all these customers never end us paying us paying us well then we have bad earnings quality. Right? So if there's this big disconnect between the cash coming in and the actual income that we're booking, well, this could signify something weird for investors, right? The earnings quality could be kind of bad. We could show all of this net income. But when we look at the cash flow statement, it's like, where is the cash? We're not receiving any cash, even though you say you have all this income. All right. So let's look at the ratio quality of earnings ratio in our numerator. We've got net cash flow from operating activities. So this comes from the statement of cash flows, right? It's gonna be on the statement of cash flows. We've got three sections on their first we show our operating cash flows, which is from our operations from our core business. How much cash are we generating from that business? Then we're gonna show investing activities which is us buying and selling fixed assets, land machinery, equipment, that kind of stuff. And then finally, we're going to have our financing activities. And that's when we're dealing with our debt holders are our long term liabilities like the bank and our stockholders when we're paying dividends or when we're selling new shares of stock. So we're focusing on the operating activities, right? The cash we can bring in from our operations and we're comparing that to net income, right? So just like we discussed above there could be that disconnect between the cash flow and net income and this is where we can analyze that. So it's gonna measure how much cash the company's operations generated for every dollar of net income, right? We're not expecting the cash flow to line up perfectly with the net income, but we're hoping that we are bringing in that cash flow and it's not just a bunch of net income and no cash coming in. So we always want to receive as much cash as possible, right? That's that's the best thing that we could do is get all that cash. So the higher this ratio, the higher the quality of earnings, right? We want this, we want these to be aligned and especially if we can receive more cash the better. Cool. So note that sometimes professors talk about quality of earnings and they're not focused on this ratio. They just discuss quality of earnings around other issues. Sometimes when we talk about quality of earnings, it's referring to that the financial information is complete and transparent, right? So this this has to do that. They're showing us income on the income statement and it's not muddled up with a bunch of weird information. No, it's transparent. We're able to understand how that income came about. Okay. And sometimes quality quality of earnings can be messed up with one time gains, right? Maybe during the period, we had a net loss, but we were holding some some stock that had gone up in value. And when we're like, well, we have a net loss that's gonna look bad to the investors. But if we sell this stock right now, it'll actually bump us up so that we actually have income and it will look good. But that's not sustainable, right? We're just selling this stock that we've been holding onto. We're not gonna be able to sell that stock every period. This is a one time thing that we're using to boost our earnings, right? So it's gonna help us satisfy the investors and this is called earnings management, right? We're managing our earnings were trying to smooth it out so it never looks like we're doing poorly, right? The management always wants to look like they're doing a good job, so they're gonna manage these earnings. So they always look, they always look nice. Okay. And then another way that quality of earnings can be messed with is companies might try to inflate their revenue through this process called channel stuffing. So if you sell to others, like if you're a wholesaler that sells to other wholesalers and then they break it up and sell it to the merchandisers or something. Well, what you could do to inflate your revenue during the period and say, hey, by all this stuff from me right now, we'll give you a good price. Just buy it all right now and encourage the customers to purchase large amounts of your goods near the end of the period. So this is going to boost up your revenue because you made a lot of sales at the end of the period. But then those customers are just gonna be sitting there with the boxes in there. They can't sell them, right. They just have all this extra inventory. They might end up having to just return it to you later and you you don't actually have all that revenue. Right? So this is another way to mess with earnings, the quality of earnings here, right? You're you're trying to show a better situation than actually exists. Okay, So this is another way we discuss quality of earnings is managing our earnings, trying to mess with what the investors see so that it actually looks better than what the real picture is. Okay, let's do a little bit of practice with the ratio for quality of earnings before we move on. All right, let's do that. Now

MoneyCo had sales revenue and net income during the current year of $100,000 and $60,000, respectively. The total amount of stockholders’ equity was $600,000. The cash flow statement indicated that cash flows from operating activities, investing activities, and financing activities, were $20,000, ($30,000), and $60,000. The company also paid dividends of $10,000. What is MoneyCo’s quality of earnings ratio?