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Quality of Earnings

Definition - What does Quality of Earnings mean?

The quality of earnings, used in the context of selling a business, usually refers to how close a company's earnings are to actual free cash flow. A company's earnings can be much different than cash flow due to accounting practices such as the depreciation method for assets, the way inventory is accounted for, working capital requirements to sustain the business, and accruals.

A company is also considered to have a high quality of earnings if it is able to influence whether these earnings go up or down. If a company can improve its earnings by generating higher revenue or decreasing costs, and is less influenced by external events, then this company is said to have a high quality of earnings.

Divestopedia explains Quality of Earnings

The quality of earnings should be considered in terms of its proximity to free cash flow when selling a business. A higher quality of earnings would pose much lower risk to a potential buyer, which would result in the company commanding a higher valuation premium. A company with a poor quality of earnings is much riskier and often requires additional asset backing to make it saleable at a reasonable earnings multiple.

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