Quality of Income Ratio

The Quality of Income Ratio is computed by dividing Cash Flow from Operating Activities (CFOA) by net income:

Quality of income = CFOA / Net income

This ratio indicates the proportion of income that has been realized in cash.As with quality of sales, high levels for this ratio are desirable.The quality of income ratio has a tendency to exceed 100% because (1) depreciation expense has reduced the denominator and (2) cash spent to replace productive assets has not been subtracted in calculating the numerator.Altron’s 1997 quality of income ratio is 98.4%.

Quality of income = $14,428 / $14,667 = 98.4%

Altron’s 1997 ratio is less than 100% and does not compare favorably to its 1996 ratio of 128%.The decline in this ratio is largely due to the growth in inventories that was mentioned previously.

In the discussion of quality of sales ratio, we indicated that revenue recognition may be judgmental. The same is true with expense recognition. A variety of alternatives for expense allocations are available to firms, and firms have considerable discretion in the selection of these alternatives. The quality of income ratio can provide an overall indication of how liberal a firm’s accounting judgments have been. Case Study 4.2 provides information about quality of income ratios in the software industry.

As with the quality of sales ratio, the quality of income ratio can help detect situations involving questionable accounting judgments. Case Study 4.1 in the section “Quality of Sales Ratio” showed that the quality of sales ratios for Cambridge Biotech and Kendall Square Research were both below 85%. Consider the following information:

Case Study 4.2

As with the quality of sales ratio, the quality of income ratio can help detect situations involving questionable accounting judgments. Reality Check 5-1 showed that the quality of sales ratios for Cambridge Biotech and Kendall Square Research were both below 85%. Consider the following information:

Cambridge Biotech Kendall Square Research
(Dollars in thousands)
Cash provided by operating activities ($5,696) ($27,194)
Net income (loss) $ 348 ($21,619)

Required

a. Compute the quality of income ratio for each firm.

b. What inferences can you draw from these ratios?

Solution

Cambridge Biotech Kendall Square Research
(Dollars in thousands)
Quality of sales = ($5,696) / $ 348 ($27,194) / ($21,619)
Net income (loss) 1,637% 126%

b. Cambridge’s negative quality of income ratio results from a negative numerator and a positive denominator. This indicates that although Cambridge generated a positive net income, its operations resulted in a net cash outflow. The ratio is quite large (in absolute terms), which should be rather alarming to financial statement readers.

Regarding Kendall Square, interpreting ratios generated from negative numbers is often difficult. A ratio of 126% usually indicates that a firm generated more cash than income. However, when a 126% ratio is computed from two negative numbers, it indicates that the firm’s cash outflow exceeded its reported loss. Both the loss and the cash outflow from operations should concern financial statement readers.

You should realize that cash flows can be manipulated by management. For example, customers can be induced to remit payments early if they are provided with a sufficiently large cash discount. Although the short-term consequences of this action may be to increase net cash flow, large discounts might not be in the shareholders’ best long-term interest.

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