Quality of Income Ratio: Definition, Formula & Analysis

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  • 0:04 Quality of Income Ratio
  • 0:51 Definition and Formula
  • 2:14 Examples
  • 3:07 High- vs. Low-Quality Earnings
  • 4:07 Lesson Summary
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Lesson Transcript
Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll discuss the quality of income ratio. We'll explain the equation and calculate the quality of income for several companies. We'll end with a brief analysis on why certain companies may have high-quality or low-quality income.

Quality of Income Ratio

You may have seen the TV show ''Inspector Gadget.'' The show followed this aloof detective as he solved crimes, often with the help of neat gadgets like a hat that had helicopter-like propellers. Well, along with the propellers, a magnifying glass came out of his hat at the touch of a button. You can think of the quality of income ratio as your own magnifying glass: it's a tool that will help you shed light on what's actually happening with a company.

In this lesson, we'll spend time helping you get comfortable using this new tool. We'll first provide a general definition and explain what the quality of income ratio is trying to uncover. We'll then calculate the ratio for several companies, then end the lesson with a discussion of why certain companies may have high quality or low income quality.

Definition & Formula

The quality of income ratio is defined as the proportion of cash flow from operations to net income. The formula for the quality of income ratio is:


income ratio1


A ratio of greater than 1.0 usually indicates high-quality income, while a ratio of less than 1.0 indicates low-quality.

So, what is quality income? Quality income refers to the amount of earnings that come from the business operations themselves. For example, if we had a lemonade stand, quality income would be income from selling the lemonade. Income that is periphery to the business, like cash we found on the street or cash from an off sale of equipment, is not quality income.

Earnings that do not come from the fundamental business are often called accounting profits. These are artificial profits that can be due to such things as:

  • Accounting policy changes
  • Foreign exchange fluctuations
  • Mark-to-mark debt securities
  • Changing the estimate of allowance for doubtful accounts
  • Changing inventory
  • Depreciation estimates

However, these are just some examples. An increase in profit due to favorable changes in these accounts will give the appearance of better performance, but that is illusory. Investors cannot touch, feel, or take those types of profits to the bank; they are simply paper profits.

Examples

So, the quality of income ratio tries to sort out companies by looking at the relationship of cash flow from operations to net income. The higher the amount of cash flow from operations that come with every $1 of net income, the higher the quality of earnings. Let's calculate the ratio for some successful companies.


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