Quality of Earnings Ratio Equation

kundoy/Moment/GettyImages

All business earnings aren't created equal: Much of your company's reported income is earned through hard work and a solid business model, but some of the income you report on financial documents may also reflect accounting conventions that can make your company's bottom line appear artificially high. A quality of earnings ratio equation helps to separate out the income your company generates through real operations versus other sources of revenue, such as a sale of assets.

Calculating Your Quality of Earnings Ratio

Calculate this ratio by dividing your net cash from operating activities by your net income for the same period. Net cash from operating activities is a line on your balance sheet that shows your available cash after adjusting for variables that don't appear on your income statement or profit and loss statement. These adjustments include working capital, such as bank loans, that aren't part of your profit and loss statement, and depreciation allowances that appear on your profit and loss statement but don't represent expenses that you actually paid during the year in question.

Reading the Numbers

A quality of earnings ratio of significantly less than 1 indicates that your net cash from operating activities is significantly less than the net income you reported for the same period. This suggests that a substantial amount of your reported net income may have come from accounting adjustments rather than actual sales of goods or services. A quality of earnings ratio of at least 1 suggests that the figure you've reported for net income is a strong representation of your company's ongoing earnings. Either way, the quality of earnings ratio expresses the relationship between the cash that your business earns on a stable and consistent basis and the numbers you report on your tax forms and financial statements.

Evaluating the Variables

A quality of earnings ratio that is greater or less than 1 doesn't necessarily indicate that your accountant is practicing sleight of hand to make your company's financial information appear different from actual fact. Accounting conventions are based on assumptions and adjustments that allow for certain liberties and judgement calls; it's natural for you and your accountant to use some of these conventions when preparing statements to make your company look appealing on applications for financing or financial statements presented to potential investors. The quality of earnings ratio is simply a way to evaluate how freely you've used these conventions and to allow the potential stakeholders to understand more about the investments they're considering.

References

About the Author

Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.