What is the quality of income?

2. Measuring the quality of income

The quality of income can be measured in a number of ways. One of the common techniques used in evaluating the quality of earnings is the ratio analysis. One of the ratios commonly used to measure the quality of earning is as follows:

Quality of Income = 

Cash Flow From Operating Activities

Net Income

A quality of income ratio higher than 1 usually indicates high quality earnings, while the ratio lower than 1 is considered to indicate low quality earnings.

In accounting, accrual earnings (i.e., net income reported on the income statement) do not necessary reflect cash flows. As the result, the logic behind the quality of income ratio is as follows: high quality earnings should reflect the cash flows (from operations) of the organization. Said another way, if each dollar of income is supported by one dollar or more of cash flow from operations, then such income has a high quality. And vice versa.

The quality of income is often measured in financial analysis.

To illustrate an example, read an extract from Dow Jones Newswire on November 11, 2008:

“For a mortgage lender that earlier this year said it was at risk of filing for bankruptcy protection, Thornburg Mortgage Inc.'s (TMA) quarterly net income of $140 million is a surprise. After all, the company is no longer making new loans… Late Monday, Thornburg reported third-quarter net income of $140 million, or $1.23 a share, compared with a net loss of $1.1 billion, or $89.41 a share, a year earlier.”

“This swing to profitability was fueled, in large part, by so-called fair value gains of about $595 million related to the company's debt. In fair value accounting, a company that is suffering from deteriorating creditworthiness books the declining value of its borrowings, or liabilities, as income.”

“Even more blunt on the subject is Robert Willens, president of Robert Willens LLC, an accounting and tax consultancy firm. ‘I think it's very clear this form of income ought to be ignored by investors,’ he said. ‘It's the lowest quality of income I can think of. It's phantom income. It's not like you can take it to a bank and do anything with it.’"

“To be sure, Thornburg is following the rules in its accounting and hasn't done anything improper. Other companies, such as banks and brokers, have also reported gains from the declining value of their own debt, leading to a boost in profit (or at least narrower losses).”

“A spokeswoman for Thornburg said the gains on the company's debt "were recorded as noninterest income related to fair value changes." She didn't have any immediate comment on analysts' views that its profit was driven by accounting rules instead of a turnaround in its operations.”

If we look at the Thornburg Mortgage Inc. quarterly report (i.e., unaudited 10-Q) for the same period – when the company recognized the $140 million net income – the company reported net cash provided by operating activities as $50.36 million, according to the SEC filings.

Thus, in this example the quality of income ratio is as follows:

Quality of Income = 

$50.36

= 0.36

$140

As we can see, the quality of income ratio is below 1, which indicates that the quality of income reported by Thornburg Mortgage Inc. in that period is low.

The news also mentioned that the year earlier the company reported a net loss of $1.1 billion. In the same period, the company reported the net cash provided by operating activities as $48.5 million. Thus, the quality of income in that period was a negative value: -0.04.

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