What is Quality of Earnings Ratio and Why Should You Care?
The Quality of Earnings Ratio helps investors and analysts gauge how much of a company's earnings come from its core business operations rather than from other, less reliable sources.
A higher Quality of Earnings Ratio generally indicates a healthier, more sustainable business. It tells you whether profits come from what the company does best, rather than from unpredictable investments or one-time gains. This insight is crucial when making investment decisions.
How to Calculate Quality of Earnings Ratio
The formula is straightforward:
[\text{Quality of Earnings Ratio} = \frac{\text{Net Cash from Operating Activities}}{\text{Net Income}}]
Where:
- Net Cash from Operating Activities is the cash generated from core business activities
- Net Income is the company's total earnings including all income and expenses
Calculation Example
- Determine net cash from operating activities: $3,000
- Determine net income: $4,500
- Apply the formula:
[\text{Quality of Earnings Ratio} = \frac{3,000}{4,500} = 0.67]
The Quality of Earnings Ratio is 0.67, meaning 67% of the company's earnings come from core operations.
| Variable | Definition | Unit |
|---|---|---|
| Net Cash from Operating Activities | Cash generated from core business | $ |
| Net Income | Total earnings including all income and expenses | $ |
| Quality of Earnings Ratio | Proportion of earnings from core operations | Unitless |
Manufacturing industries often have higher ratios because earnings are driven primarily by operational activities. This ratio is your financial health checkup for businesses!