Question

The quality of a company's earnings and sustainable income are both important to analysts and investors. Examine the difference between the quality of earnings for a company and sustainable income. Discuss the relevancy of pro forma statements to sustainable income and quality of earnings. As an investor assume you can select information related to either quality of earnings or sustainable income prior to making a decision to invest in a company. Identify your selection and support your response with an example.

Answer 1

Solution:

1.Sustainable Income:

sustainable income is the income that is most likely to be obtained in the future.

Net income should be adjusted to irregular revenues, expenses, gains or losses to obtain the sustainable income.

Since these revenue or expenses or gains or losses are not regular so, these should be eliminated while estimating companies sustainable income from net income.

For example a company has a net income of $850950. and it includes a gain on sale of plant and machinery of $12500, loss due to floods amounting to $85700.

In order to derive the company's sustainable income the amount of loss occurred due to floods and gain on sale of plant and machinery should be eliminated.

This helps the investors to determine the actual sustainable income of the company that could be earned by the company in the future years without the noise of irregular incomes, expenses, gains or losses.

2. Quality of Earnings:

Quality of earnings refers to the proportion of income attributable to the core operating activities of a business.

A company's quality of income is said to be high when it's profit is high which results due to increased sale or reduction in costs.

Many factors that effect the quality of income are alternative accounting methods.

For example few companies use FIFO whereas some companies use LIFO to value their inventories. If suppose inventory is a significant asset to both the companies it is unlike that their current ratios are comparable.

Investors like to see high-quality earnings, since these results tend to be repeated in future periods which in turn provides more cash flows for the investors.

Thus, entities that have high-quality earnings are also more likely to have high stock prices due to increased demand to their stock.

It is advisable to consider the sustainable income basis to invest in the company since it shows the actual income derived by the company after eliminating the irregular incomes, expenses gains or losses.