Quality of Earnings Analysis Tells the Story Behind a Company’s Numbers

A key financial metric that tells an important story for many businesses is a quality of earnings (QoE) report. While it often is included as part of the due diligence process associated with a merger, a QoE can provide useful insights in many situations, such as during analysis of a particular division or subset of a company’s overall operations.

The key purpose of a QoE analysis is to go beyond the company’s earnings numbers and reveal the meaning – and the quality – behind them.

What does ‘Quality of Earnings’ Mean?

A quality of earnings report provides an analysis of the factors behind a company’s earnings numbers. By dismissing any anomalies, accounting strategies or one-time events that may skew the bottom-line numbers, the sustainable earnings number that is likely to recur from year to year is revealed.

The QoE is used to assess the accuracy of historical earnings and the achievability of future projections. In an acquisition scenario, given that valuations are often based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), a potential buyer must have an understanding of historical revenues, trends, assumptions used in forecasts and the sustainability of earnings.

For internal use, a QoE can help management plan for outside investment, growth, operational changes, new product lines and other opportunities.

Since a QoE report is based on a company’s unique financial and operational metrics, it will not look the same for every company. It’s not an audit report, nor is it part of a typical financial statement. Its value is in the analysis of underlying fundamentals and the fact that it can be crafted to fit a particular company’s financial and operational profile, providing a highly accurate reading.

Components of a QoE Analysis

Since a QoE is customized to the needs of the situation, its components can be very different from one company to another. In general, high-quality earnings are associated with conservative accounting practices, and that story is told in the individual components of the analysis. Some of the key components of a QoE report typically include:

§  Executive Summary – This provides an overview of the business, including location, founding details and management structure. It should also summarize transaction specifics, such as the acquisition of assets and the purchase price.

§  Income Statement Analysis – This will evaluate the company’s net income and identify any anomalies or accounting strategies; remove one-time events that may distort the bottom-line numbers; focus on earnings derived from higher sales or lower costs, and examine working capital trends. This analysis also considers external factors that can impact earnings quality, such as inflation.

§  Balance Sheet Analysis – This analysis tracks activity from the income statement through to the balance sheet and cash flow statement. It ensures consistency and reliability of financial information and highlights any discrepancies or unusual items.

§  Cash Flow Assessment – This assessment examines cash flow from operations and highlights any unusual activity. For example, an increase in net income without a corresponding increase in cash flow is a red flag.

§  Operational Analysis - This component analyzes a company’s processes and performance, comparing current and past analyses and pinpointing areas for improvement. It may also include what-if scenarios for different performance levels, expense management, and workforce management.

Role of QoE in M&A

A QoE analysis plays a critical role in business acquisitions by providing valuable insights into the sustainability and reliability of a company's earnings. It impacts valuations, negotiations and the overall decision-making process in several important ways:

Valuations

• Accurate Assessment – Quality of earnings analysis helps in accurately assessing the true earning power of the target company. It identifies any one-time or non-recurring items that may artificially inflate or deflate earnings, allowing for adjustments to be made to the valuation.
• Risk Assessment – By examining the quality of earnings, potential risks such as revenue volatility, unsustainable cost structures or accounting irregularities can be identified. This leads to a more realistic valuation that considers the long-term stability and growth potential of the target company.

Negotiations

• Informed Negotiations – A thorough QoE analysis provides buyers with a deep understanding of the target company's financial health. Armed with this information, buyers can negotiate from a position of strength, addressing any concerns about the sustainability of earnings and potential risks.
• Mitigating Risks – Sellers may attempt to inflate earnings or conceal liabilities during negotiations. The QoE analysis helps in uncovering such discrepancies, enabling buyers to mitigate risks and negotiate more favorable terms.

Decision-Making Process

• Integration Planning – Understanding the quality of earnings allows an acquiring company to better plan for post-acquisition integration by identifying areas that may require operational improvements or cost-saving measures to enhance the target company's profitability.

Challenges of Conducting a QoE Analysis

Conducting a QoE analysis involves navigating several challenges and complexities that revolve around accounting policies and practices, revenue recognition methods and external factors impacting earnings. Professional judgment, combined with extensive experience in financial analysis and due diligence, is crucial for conducting a thorough quality of earnings analysis that provides actionable insights for investors, acquirers and decision-makers. Some key points to consider include:

Accounting Policies and Practices

• Diversity of Standards – Different companies may follow different accounting standards (e.g., GAAP, IFRS), leading to variations in how they recognize revenue, report expenses and handle non-recurring items. This diversity can make it challenging to compare the quality of earnings across companies accurately.
• Subjectivity – Accounting policies often involve subjective judgments, such as the estimation of allowances for doubtful accounts, depreciation methods and contingent liabilities. These subjective elements can affect the reported earnings and may require careful analysis to assess their impact on the quality of earnings.

Revenue Recognition Methods

• Complex Revenue Streams – Companies with complex revenue streams, such as long-term contracts, subscriptions or licensing agreements, may use different methods to recognize revenue over time or at a point in time. Understanding these methods and their implications for earnings quality is crucial for a comprehensive analysis.
• Contractual Obligations – Assessing the quality of earnings also involves examining the terms of contracts and agreements to ensure that revenue recognition aligns with the delivery of goods or services and reflects the economic substance of transactions.

Impact of External Factors

• Economic Environment – Economic conditions, industry trends, competitive pressures and regulatory changes can all influence a company's earnings. Analyzing how external factors impact earnings stability and growth potential is essential for a thorough quality of earnings assessment.
• Market Fluctuations – For publicly traded companies, fluctuations in financial markets, interest rates, exchange rates and commodity prices can affect earnings volatility and require careful consideration during the analysis.

Professional Judgment and Experience

• Interpretation of Data – Conducting a thorough quality of earnings analysis requires professional judgment to interpret financial data accurately. This includes understanding the nuances of accounting principles, recognizing potential red flags or anomalies, and making informed adjustments where necessary.
• Experience – Experienced financial professionals, such as accountants, auditors and financial analysts, bring a wealth of knowledge and experience to the quality of earnings analysis. Their experience allows them to identify key issues, assess risks effectively and provide meaningful insights to support decision-making.

Benefits of a High-Quality Earnings Report

A high-quality QoE indicates transparent, reliable financial reporting, which is fundamental for building trust with stakeholders. A strong QoE report can help increase investor confidence, improve stock performance and drive financial planning and operational decision making.

Working with experienced professionals who understand QoE analysis and its importance to your company’s success is key to building an accurate report that provides insightful, actionable information to all stakeholders. Contact your Frost PLLC advisor for a meeting.