Quality of Earnings
Two companies can report the same profit and one of the numbers is more likely to persist. Quality is about persistence and about how much of the profit is cash.
MadStockAlerts Research · Updated August 28, 2026
What to take away
- High-quality earnings are backed by cash and are repeatable.
- Accruals are the least persistent component of reported profit.
- Persistent gaps between profit and operating cash flow are the central warning.
- One-off gains and tax effects inflate a number that will not repeat.
- The assessment is made across years rather than from one statement.
MAD Academy Training Video · 0:44
Are the Profits Real?
Quality of earnings asks whether reported profit is backed by cash and likely to repeat — two questions the income statement never answers.
This lesson is part of a Stock Alerts + Tools plan.
What quality means here
The term is used loosely and has a specific content: earnings are high quality when they are likely to persist and are backed by cash. Both properties can be assessed from published statements.
| Higher quality | Lower quality |
|---|---|
| Cash flow tracks profit | Profit persistently exceeds cash flow |
| Few adjustments, and they vary | The same adjustment every year |
| Growth from volume and price | Growth from acquisitions and one-off items |
| A stable effective tax rate | Profit boosted by a one-time tax benefit |
| Consistent accounting policies | Estimates and lives revised in a favourable direction |
The accruals finding
Research separating earnings into a cash component and an accrual component has found the accrual component substantially less persistent: companies with high accruals relative to earnings have tended to see profit deteriorate subsequently.
accruals = net income - cash flow from operations
- scaled by total assets to make it comparable across companies
- a large positive figure means profit is heavily accrual-based
The proposed explanation is that accruals require estimates, estimates are discretionary, and discretion is exercised in the direction management prefers. The effect is one of the more durable findings connecting accounting to subsequent returns.
The checks
- 1Compare cumulative profit against cumulative cash flowOver three to five years. They should converge, because accruals reverse.
- 2Read the tax reconciliationA low effective rate driven by a one-off item is not repeatable.
- 3Count the adjustmentsAn item excluded every year is a cost, whatever it is called.
- 4Check the components of growthOrganic against acquired, which segment disclosure and the cash flow statement together reveal.
- 5Look for changes in estimatesUseful lives, allowances and reserve assumptions, which the notes disclose.
Scroll the chart sideways to see all of it.
- Net income
- Cash from operations
What it does not establish
A low quality-of-earnings assessment is not an allegation. Aggressive accounting is legal, disclosed and common, and the great majority of companies with heavy accruals are not doing anything improper. What the assessment says is that the reported number is less likely to persist.
The composite scores, and their limits
Several published scoring models combine accounting ratios into a single number intended to flag manipulation or distress. They are worth knowing about and worth treating as screens rather than as verdicts.
- They combine ratios such as days sales in receivables, gross margin trends, asset quality and accruals.
- They were fitted on samples of companies known to have manipulated, which is a small and specific population.
- They produce a large number of false positives, since most companies with unusual ratios are not manipulating.
- They are transparent, which means their inputs can be examined individually rather than trusted as a score.
The third item is decisive for how they should be used. A model with a high false positive rate identifies companies whose filings deserve reading, and treating a score as a conclusion misuses it in exactly the way the fraud pillar warns against for any single indicator.
The underlying ratios are the useful part, and each of them is computable from the statements without any model. The score is a way of ranking; the ratios are what can actually be examined.