Earnings Quality Trend: Method

Earnings Quality Trend: Method

What it does

Net income is not cash. It is measured on the accrual basis: revenue is counted when it is earned and costs when they are incurred, whether or not money has changed hands, so every profit figure contains estimates (how much customers will pay, how long equipment will last, what stock is worth). Earnings quality is a loose name for how closely reported profit follows the cash collected and the assets on the balance sheet. This page reads the annual reports a company filed with the U.S. Securities and Exchange Commission (SEC) for up to ten fiscal years and lays out, year by year, a set of published checks of that link. It reports the numbers and what a change in each one means mechanically. It gives no opinion on the company or its accounting.

The numbers come from a copy of the SEC's public data held on this site (about 640 companies, annual figures, each in the currency the company reports in). Nothing is fetched when you open the page.

The method

In every formula, subscript B is the fiscal year in question and A the fiscal year before it. Balance-sheet lines are year-end balances. A year has a "year before" only when that year is on file in the same currency.

Cash conversion and accruals. With NI net income, OCF cash from operating activities and TA total assets:

cash conversion = OCF / NI, shown when NI is positive
average total assets TA_avg = (TA_A + TA_B) / 2
accruals ratio, cash-flow form = (NI − OCF) / TA_avg
accruals, balance-sheet form = (ΔCA − ΔCash) − (ΔCL − ΔSTD) − D&A
accruals ratio, balance-sheet form = accruals / TA_avg

Δ is the change from year A to year B; CA is total current assets, Cash is cash plus short-term investments, CL is total current liabilities, STD is short-term debt and D&A is the year's depreciation and amortization. The balance-sheet form is the one Sloan (1996) studied; Hribar and Collins (2002) showed that it is disturbed by acquisitions, disposals and currency translation and proposed the cash-flow form. Both are shown where the lines exist.

Receivables and inventory. With Rev revenue, AR accounts receivable, CoR cost of revenue and Inv inventory:

growth of a line = line_B / line_A − 1 (when line_A is positive)
days sales outstanding DSO = 365 × AR_B / Rev_B
days inventory DIO = 365 × Inv_B / CoR_B

The table sets receivables growth beside revenue growth, and inventory growth beside the growth of cost of revenue, with the difference of each pair in percentage points. The receivables comparison is one of the indices of Beneish (1999).

Margins, capital spending, tax.

gross margin = gross profit / revenue; operating margin = operating income / revenue
capital spending to depreciation = capital spending / D&A
effective tax rate = income tax expense / income before tax, shown when income before tax is positive

Share-based compensation and the share count. With SBC the share-based compensation expense and N the diluted weighted-average share count (adjusted for stock splits):

free cash flow FCF = OCF − capital spending
free cash flow after share-based compensation = FCF − SBC
change in the share count = N_B / N_A − 1

Piotroski F-score. Nine tests of year B against year A, one point each (Piotroski, 2000): return on assets positive; operating cash flow positive; return on assets higher; operating cash flow above net income; long-term debt to assets lower; current ratio higher; share count not higher; gross margin higher; asset turnover (revenue / assets) higher. The page computes it for every year that has a year before, with the same routine and the same convention as this site's Financial Quality Scores tool (each ratio on the balance sheet at the end of its own year; shares outstanding at the year end).

What it assumes

• That the company reports each line under a standard tag. A line under a tag of the company's own is not found and the measures that need it stay blank. Blank never means zero.
• That one year can be compared with the next. A change of fiscal year end, a large acquisition or a change of reporting currency breaks that; across a currency change the page withholds growth rates and averages.
• That year-end balances stand for the year. Days sales outstanding and days inventory use the closing balance, not an average over the year.
• That the company makes or sells goods or services. For banks, brokers and insurers (SIC 6000 to 6799) the cash-flow, working-capital and F-score rows are marked n/m, not meaningful.
• For the F-score: that all ten lines it needs are tagged in both years. A missing line gives no score; the page does not guess.

When it misleads

• A ratio to a small number. When net income is close to zero, cash conversion is very large and says little; the page shows no ratio to a loss and says when net income is under 1 % of revenue. Growth from a small base (inventory of a company that holds little) swings widely for the same reason.
• High cash conversion is not always operating strength. A company with large amortization of acquired intangibles, or large share-based pay, reports cash flow far above net income every year. That is how its accounts are built.
• Acquisitions. A purchase adds the target's receivables and inventory at once but only part of a year's revenue, so receivables and inventory appear to outgrow sales, and the balance-sheet accruals jump. The cash-flow form is less affected.
• Working capital has many drivers. Rising days sales outstanding can be longer payment terms, a shift toward customers who pay later, sales bunched at the year end, or a change in what the company counts as receivables. The number does not tell which; the notes to the filing do.
• Margins move for business reasons. Price, product mix, input costs and scale move margins far more often than accounting choices do.
• The tax rate is lumpy. One-time items (a law change, a settlement, a write-down of deferred tax assets) can move the effective rate by many points in one year.
• The F-score is a count. Each test is pass or fail, however small the change, and the nine are weighted equally. Piotroski built it on companies with a high book-to-market ratio between 1976 and 1996; nothing says it carries over to other companies or periods. A company with no long-term debt tagged, or with several share classes and no single share count, gets no score here.
• Restated years. The data keeps the latest value filed for a year, so a restated year differs from the report first filed.

Worked example

Apple Inc., fiscal year ended 26 September 2026 (B) against the year ended 27 September 2025 (A), in millions of US dollars as held in the data: net income 132,175; cash from operating activities 145,097; total assets 359,241 (A) and 404,548 (B); revenue 416,161 and 478,834; receivables 39,777 and 43,817; cost of revenue 220,960 and 245,232; inventory 5,718 and 14,541; gross profit 233,602; operating income 158,063; capital spending 9,041; depreciation and amortization 13,423; income tax 27,062 on income before tax of 159,237; share-based compensation 13,789; diluted shares 15,004.70 and 14,720.31 million.

cash conversion = 145,097 / 132,175 = 1.10
average total assets = (359,241 + 404,548) / 2 = 381,894.5
accruals ratio, cash-flow form = (132,175 − 145,097) / 381,894.5 = −3.38 %

Balance-sheet form, with current assets 147,957 and 173,857, cash and short-term investments 54,697 and 56,722, current liabilities 165,631 and 169,915, short-term debt 20,329 and 11,903:

accruals = (173,857 − 147,957) − (56,722 − 54,697) − (169,915 − 165,631) + (11,903 − 20,329) − 13,423 = −2,258
accruals ratio, balance-sheet form = −2,258 / 381,894.5 = −0.59 %

revenue growth = 478,834 / 416,161 − 1 = 15.1 %; receivables growth = 43,817 / 39,777 − 1 = 10.2 %
days sales outstanding = 365 × 43,817 / 478,834 = 33.4 days
cost of revenue growth = 245,232 / 220,960 − 1 = 11.0 %; inventory growth = 14,541 / 5,718 − 1 = 154.3 %
days inventory = 365 × 14,541 / 245,232 = 21.6 days

gross margin = 233,602 / 478,834 = 48.8 %; operating margin = 158,063 / 478,834 = 33.0 %
capital spending to depreciation = 9,041 / 13,423 = 0.67; effective tax rate = 27,062 / 159,237 = 17.0 %

share-based compensation = 13,789 / 478,834 = 2.88 % of revenue
free cash flow = 145,097 − 9,041 = 136,056; after share-based compensation = 136,056 − 13,789 = 122,267
change in the share count = 14,720.31 / 15,004.70 − 1 = −1.90 %

The F-score of fiscal 2026 against 2025 is 9: all nine tests pass on the figures as held in the data.

A calculator for education and analysis, not investment advice.