Alright. Let's discuss another concept here, quality of earnings. And let's start with the quality of earnings ratio. The quality of earnings ratio measures the comparison of our incoming cash flows from operations with net income. This can be quite interesting because, as you remember, cash flow and income don't always align with each other. Quality of earnings is a common profitability ratio where we analyze the profitability of the company, not just from an income perspective but from a cash perspective. However, remember that income and cash flow are not directly aligned always in accrual accounting since we're doing accrual accounting here. Sometimes, when we book revenues, it's not necessarily the case that we receive the cash right away. We book the revenue when we provide service to the customer, even if they haven't paid us for it. When we've done our part of the bargain for the customer, we take the revenue, even if we haven't received the cash. So, in this situation, we might make a journal entry like accounts receivable because they're going to pay us later, and then we're going to credit revenue. We're taking revenue in the current period, even though we haven't received the cash from that revenue. This could be a problem. What if we never received that cash? If we're booking all these revenues, we say, 'Here. Yes. Buy our product. Take our product. You can pay us later.' But what if we never see that cash? Then, we have bad earnings quality. If there's a big disconnect between the cash coming in and the actual income that we're booking, this could signify something problematic for investors; the earnings quality could be bad.
Let's look at the ratio. In the numerator of the Quality of Earnings ratio, we've got net cash flow from operating activities from the statement of cash flows. The statement of cash flows features three sections: operating cash flows, which come from our operations, core business, and show how much cash we are generating from that business; investing activities, which involve buying and selling fixed assets like land, machinery, and equipment; and financing activities, which deal with debt holders, long-term liabilities like the bank, and stockholders, including actions such as paying dividends or selling new shares of stock. We're focusing on the operating activities, the cash we can bring in from our operations, and we're comparing that to net income. As discussed, there could be a disconnect between the cash flow and net income. This measure, then, analyzes how much cash the company's operations generated for every dollar of net income. We're not expecting the cash flow to line up perfectly with the net income, but we're hoping that we are bringing in that cash flow. The higher this ratio, the higher the quality of earnings. We want these to be aligned, especially if we can receive more cash.
It’s important to note that sometimes professors talk about quality of earnings, and they're not focused on this ratio. They discuss quality of earnings around other issues. Sometimes when we talk about quality of earnings, it refers to the financial information being complete and transparent. This means showing us income on the income statement that's not muddled up with a bunch of ambiguous information. Other times, quality of earnings can be affected by one-time gains. Maybe during the period, we had a net loss, but we were holding some stock that had gone up in value. Selling that stock at the right moment could boost our observed earnings, making it look better to investors, but this is not sustainable. This is called earnings management, where earnings are manipulated to never appear weak. The management always aims to appear competent, so they manage these earnings to always look favorable. Another way that quality of earnings can be manipulated is through a process called channel stuffing. Here, a wholesaler might encourage customers to purchase large amounts of goods at the end of a period to inflate revenue, but if these customers can't move the stocked goods, they may return them, nullifying the perceived revenue gain. This, too, is a way to misrepresent the actual financial situation to make things look better than they truly are.
Let’s now practice a bit more with the ratio for quality of earnings before we move on.
