We often look at Net Profit as a measure of earnings of the company. Earnings Increased due to increased sales and improved cost controls are of a higher quality than artificial profits created by inflation of inventory or other asset prices. Factors that determine earnings quality are;
Risks posed by the Environment in which the company operates like competition, the uncertainty of the economy, inflation, compliance requirements, fashion, taste, and Government.
- The selection of Accounting principles also plays a role, conservative approach gives high-quality income and aggressive approach leads to a low quality of income.
- The character of the management: This cannot be quantified but we can observe through accounting policies used by management.
Earning persistence
More consistent earnings is more better the Company is; you need to determine how much of the income this year is going to continue in future.
Some factors need to be considered to learn more about Earning Persistence of a Company.
- Earnings variability and its causes, it can be inflation or business cycle.
- Earnings trend analysis.
- Management incentives make it ethical issues if management is manipulating profits etc.
- No Earnings Management; need to know if accounting policies and method are selected with ulterior motives. Being vigilant if management has been changing assumptions. Moving Revenue to next periods, Asset write off at profitable year.