Quality of Earnings Ratio Equation
Earnings can come through a number of channels. In some cases, companies may be able to use aggressive accounting methods to claim a higher income than what they truly have. One of the main reasons a company would do this would be to make its financial position look stronger and thus add value to its stock. The quality of earnings ratio, or quality of income ratio, provides a way of identifying the legitimacy of a company's claims of high income.
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Net Income
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A company's quarterly or annual balance sheet displays its net income. This is often the number a company reports to the general public as its earnings for the purpose of stock valuation and establishment of credit worthiness. According to Investing Answers, net income is what is left when you take a company's total revenue and subtract taxes, operational costs, preferred stock dividends and interest paid.
Cash from Operations
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The cash a company receives from operations is the cash it earns by performing the tasks for which it is in business. A grocery store's cash from operations, for instance, is how much it profits from selling groceries. This number is an important aspect in the calculation of earnings quality because it is a real, solid, verifiable representation of the company's ability to do business effectively.
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Taxable Income
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Companies want their reported income to be high to add value to stock and lend a general sense of security to the company's current situation. Conversely, they want taxable income to be low because a low taxable income number requires them to pay less money in taxes. By looking at the income on which a company actually pays taxes, an analyst can judge the validity of reported income numbers.
Equations
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Analysts and accountants may use a number of different methods to compute a quality of earnings ratio. The first way is with this equation: (cash from operations) / (net income). This equation yields a ratio that shows the extent to which a company can verify its reported income through hard operational earnings rather than through aggressive accounting methods. High numbers show a high quality of earnings. Another common way of calculating this ratio is with this equation: ((reported income) - (taxable income)) / (reported income). This second equation yields a ratio that shows how relevant the difference is between the income a company has reported and the income for which a company has paid taxes. Low numbers show a high quality of earnings.
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