Quality of earnings
In one sentenceThe extent to which reported profit reflects a real, recurring ability to generate cash, apart from non-recurring items and optimistic accounting estimates.
Simply put
High-quality profit comes from the core business, recurs every year, and turns into cash. Low-quality profit may come from a one-time asset sale, from reducing a provision, or from credit sales that are not collected.
A quick indicator: divide operating cash flow by net profit. A ratio close to 1 or above it is reassuring, and a low ratio for several years deserves investigation.
Worked example
An appliance store reported net profit of 500,000 SAR, while its net operating cash flow was only 200,000 SAR because receivables rose.
Net operating cash flow200,000 SAR
Net profit500,000 SAR
Quality indicator = 200,000 ÷ 500,0000.4 times
Formula: Net operating cash flow ÷ net profit
Don't confuse it with
Net profitNet profit is the figure itself; quality of earnings is a judgment on its source, how repeatable it is, and whether it turns into cash.