How to Calculate Quality of Earnings

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Earnings quality is a very challenging concept. It involves in-depth financial analysis of a company and a great deal of judgment. The most efficient method for calculating earnings quality uses estimates of income that is sustainable and constant over time.

Carefully read the financial statements of the company being analyzed.

Break out various categories of earnings that the company reports into as many categories possible. For example, a company might have a mixture of earnings from long-term sales contracts and one-at-a-time deals, or earnings that depend on variable prices.

Analyze the income from long-term sale contracts. For example, the company might have 10 key customers that have contracts that pay fixed amounts of fees over several years. These earnings can be counted at face value, or 100 percent.

Subtract one-time transactions from earnings, because these deals might not be repeated in the next or following years.

Determine the variable prices that affect earnings that are not based on fixed fees. For example, a company might have earnings that are based on the price of wheat, which can fluctuate over time.

Research the variable prices over several years to calculate the average price over time.

Multiply the company's sales volumes that are based on variable prices times the average price to get a more conservative estimate of the income that might be achieved over a long period of time.

Add together the sales from the fixed-fee contracts to the sales from average variable prices. These two sets of earnings together represent the quality income you can expect to be generated by the company over time.

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About the Author

Tom McNulty is a consultant and a freelance writer based in Houston, Texas. He holds degrees from Yale and Northwestern, and has worked in banking, government, and in the energy industry. McNulty has published several articles for eHow on a variety of finance, accounting, and general business issues.

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