We are independent & ad-supported. We may earn a commission for purchases made through our links.

Advertiser Disclosure

Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.

How We Make Money

We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently from our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.

What is Earnings Quality?

Malcolm Tatum
Updated May 16, 2024
Our promise to you
SmartCapitalMind is dedicated to creating trustworthy, high-quality content that always prioritizes transparency, integrity, and inclusivity above all else. Our ensure that our content creation and review process includes rigorous fact-checking, evidence-based, and continual updates to ensure accuracy and reliability.

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

Editorial Standards

At SmartCapitalMind, we are committed to creating content that you can trust. Our editorial process is designed to ensure that every piece of content we publish is accurate, reliable, and informative.

Our team of experienced writers and editors follows a strict set of guidelines to ensure the highest quality content. We conduct thorough research, fact-check all information, and rely on credible sources to back up our claims. Our content is reviewed by subject matter experts to ensure accuracy and clarity.

We believe in transparency and maintain editorial independence from our advertisers. Our team does not receive direct compensation from advertisers, allowing us to create unbiased content that prioritizes your interests.

"Earnings quality" is a term that is used to describe how earnings are recognized within an accounting process. Defining the quality of earnings is important to the process of understanding exactly how any revenue generated came about, which in turn can sometimes yield ideas on how to build on those methods. Depending on the outcome of this assessment of the earnings, the value of the company’s stock may be justified, or considered to be undervalued or overvalued.

While there are different ways of going about determining earnings quality, one basic approach calls for defining any given earnings source as high-quality or low-quality. High-quality earnings result from a strong and consistent cash flow, often coupled with accounting standards that are considered somewhat conservative. Low-quality earnings would typically relate to some sort of artificial factor, such as attempts at creative accounting or the impact of a sudden increase in inflation on the cost of finished goods offered for sale. While artificial factors such as shifts in the general economy will have some impact on the bottom lines of most companies, the goal is to determine if that effect is sufficient to offset the otherwise strong cash flow that is a sign of a healthy company.

The distinction in earnings quality is very important, since identifying each source of earnings as high- or low-quality makes it easier to determine if the current value of the company’s stocks have adequate support. For example, if the earnings quality of a business is primarily based on strong cash flow, then there is a good chance that the shares issued have adequate backing and that the current price per share is justified. At the same time, if the apparent profitability of a company is due more to the fact that it makes use of accounting ethics that are legal but somewhat questionable, effectively generating the illusion of higher profits, then there is a good chance the stock price associated with the company shares is not reasonable, and the shares are overvalued.

Part of the process of selecting investments wisely is to ascertain the earnings quality associated with a given company before actually buying any of its outstanding shares. While there are exceptions, companies that tend to have low cash flows and are somewhat creative in how profit figures are determined will not constitute a secure investment. For this reason, many investors will consider a business with a steady cash flow and an accounting process that provides full disclosure to be a better investment opportunity.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Malcolm Tatum
By Malcolm Tatum , Writer
Malcolm Tatum, a former teleconferencing industry professional, followed his passion for trivia, research, and writing to become a full-time freelance writer. He has contributed articles to a variety of print and online publications, including SmartCapitalMind, and his work has also been featured in poetry collections, devotional anthologies, and newspapers. When not writing, Malcolm enjoys collecting vinyl records, following minor league baseball, and cycling.

Discussion Comments

By MrMoody — On Mar 04, 2012

@allenJo - I think low cash flows are common when a business is in startup mode. So that alone won’t tell you anything about the earnings quality assessment.

How do you know if a company is creative in its accounting? Well there are a few ways. I’ve heard of this concept called “earnings management” which companies use to embellish their books.

Maybe they tell you that revenue is up, for example, but they don’t tell you that profit margins have been squeezed thin because of increased competitive pressures. That’s one possibility I suppose. But nowadays most companies have to be pretty up front about this kind of stuff, so I think it’s hard to get away with it personally.

By allenJo — On Mar 04, 2012

@everetra - Well the quality of earnings assessment is easy based on cash flow according to this article. Whether that indicates that the accounting involved is “creative” or not, I don’t know.

I can tell you that I once worked for a company that was hemorrhaging cash each month. They were up front about their cash flow problems. I actually knew when “D Day” was, based on their cash on hand and their quarterly statements. They weren’t necessarily creative (they were honest) but the quality of their earnings was below par in my opinion.

Eventually they filed for bankruptcy. Sometimes the writing is indeed on the wall.

By everetra — On Mar 03, 2012

I dislike the term creative accounting – or more specifically, I dislike the concept. It’s an oxymoron. Creative and accounting are two words that should not go together.

Accounting is about hard numbers, facts and figures. There should be little room for imagination. So if a company is employing creative accounting it’s best to steer as far away as possible. Creative accounting is sure to impact the earnings quality analysis.

The question is, how do you determine if the company is being creative or not? You really have to drill down into the numbers, at a very granular level, to see what they’re doing. This is the domain of analysts in my opinion. I guess I’ll have to trust their buy and sell recommendations.

Malcolm Tatum

Malcolm Tatum


Malcolm Tatum, a former teleconferencing industry professional, followed his passion for trivia, research, and writing...
Learn more
SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.