The quality of earnings refers to the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies.
One measure of fundamental analysis that analyst like to track is net income. It provides an overview of how well the company is doing from an earnings perspective. If net income is higher than it was last year and/or beats analyst estimates, it represents a win for the company, but how reliable are these earnings? Due to myriad accounting conventions, companies can manipulate earnings to serve their own needs. Some companies seek to manipulate earnings down to pay lower taxes, while others find ways to artificially inflate earnings, especially in times of earnings decline. Companies that manipulate earnings are said to have poor or low earnings quality, conversely, companies that do not manipulate earnings have a high quality of earnings.
There are many ways to gauge the quality of earnings. Start with the top of the income statement, which can be found in the annual report, and work down. Companies with high or growing sales may also have high growth in credit sales. Changes in credit sales or accounts receivable can be found on the cash flow statement. Analysts don't like sales growth due to a loosening of credit terms. Working down the income statement, analysts also look for variations between cash flow and net income. A company that has a high net income and negative cash flows from operations may be achieving earnings through artificial means. One-time adjustments to net income, also known as non-recurring expense, are also a red flag. It is not unusual for companies to make supposedly one-time adjustments for several quarters and years in a row.
It should also be noted that companies can manipulate popular earnings measures such as earnings per share and price to earnings ratio by buying back shares of stock, which reduces the number of shares outstanding. In this way, a company with declining net income may be able to post earnings per share growth. Since earnings go up, the price-to-earnings ratio goes down as well, signaling that the stock is undervalued or on sale. In actuality, the company simply repurchased shares. It is particularly concerning when companies take on additional debt to finance stock repurchases.