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What does the Quality of Earnings Ratio tell me about my business or a business I want to buy?
The Earnings of your business can be manipulated by the use of accruals, debtors, creditors, stock levels, and provisions.
Quality of Earnings shows the difference between your Net Profit and Cash Flow from Operations. The greater the difference between these two amount the greater your concern or need to investigate further.
To calculate this, you will need:
1. Cash from Operations;
2. Net Profit; and
3. Average Assets.
Cash from Operations will usually be disclosed in the Statement of Cashflows for your business. If this is not available then an estimate can be calculated as follows:
2. Income Tax Expense
The formula is (Net Profit – Cash Flow from Operations) / Average assets
For Example, from looking at the profit and loss and balance sheet you can see the following:
- Cash Flow from Operations $300,000
- Net Profit $700,000
- Assets at the end of previous financial year $5,000,000
- Assets at the end of the current financial year $5,500,000
(700,000 - 300,000) / $5,250,000
The Quality of Earnings Ratio is 8%.
If you would like to discuss further please contact us:
McNamara and Co - Chartered Accountants, located minutes from the Melbourne CBD
Phone +61 3 9428 1062
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