Quality of income ratio - Essay Example

Accounting “Quality of Income Ratio” Analysis & Discussion By 16 May 16 May The ratio analysis of firms provides an explanation to the numbers present in the financial statements of the firm. Merely looking at the data present in an organization’s financial statement does not give a complete picture of the position of the organization. The ratio analysis explains the solvency, financial standing, liquidity, profitability and other facts about the firm’s financial position. This assignment will study and analyze the quality of income ratio and its usage for the company.

For any company earning is an essential part of its existence and while evaluating the earnings, analysts look at both the variability and quality of earnings. The ‘Quality of Net Income’ is a ratio of cash from operating activities to net income; it shows how much cash each dollar of net income generates. The cash from operating activities has a financial perspective rather than a profit oriented one. It explains the short term liquidity of the company along with the long term solvency. A firm may have a positive net income but may not be able to pay off its debts; however, the cash from operating figure is the cash figure in the bank that can be used against loan payoffs.

“Earning quality generally refers to the degree of correlation between a firm’s economic income and its reported earnings determined by the generally accepted accounting principles (GAAP).” (Raiborn 254) The quality of income exceeds 100% because depreciation and amortization and other non cash expenses based upon the accounting principles used by the firm. Looking at the quality of income ratio of the two firms Decker Outdoor Company and Timberland Company gives us good insight about the quality of their earnings.

The first company DECK shows a quality of income ratio of less than one for two consecutive years indicates that the firm might need to raise money to fund its operations. However as we see that in the year 2009 the ratio shows that the firm generates around $1.59 for every dollar of the net income showing an improvement in the quality of earning for the firm which may be a result of the higher sales for the firm. Now looking at the figures for the second company, TBL shows a ratio closer to 1 for the year 2007 and a greater than one figure for both year 2008 and 2009.

The company shows good quality of earnings and although the ratio for 2009 is less than 2008 but it is more than double and shows tat the firm has more than double cash to pay its debt as compared to its net income. Comparing the two companies the TBL shows better quality of earnings as compared to DECK for each of the three years. Although looking at the ratio, the net income figure will generally be less than the cash from operating income because of the non cash expenses but this does not undermine the usability of this ratio.

This ratio is a good number to use for knowing how much cash is available at hand for the firm to use. The ratio is useful for year to year comparison of the firm’s earnings, a positive figure shows strong financial position of the firm and a figure below 1 for a prolonged period indicates that the firm might require funding for its operations. Reference Cited Raiborn, Cecily A. Core Concepts of Accounting. 2nd Ed. New Jersey: John Wiley & Sons, Inc., 2010. 254. Print.