What is quality of earnings?

Quality of earnings refers to how accurately a company’s reported earnings reflect its true financial performance. It involves removing distortions caused by anomalies, one-time events, accounting tricks, and external factors like inflation. By filtering out these elements, analysts and investors gain a clearer, more accurate view of a company’s financial health.

When earnings are calculated conservatively, they’re generally considered more reliable than those calculated through aggressive accounting policies, which tend to obscure poor sales or increased business risk. Companies that adhere closely to Generally Accepted Accounting Principles (GAAP) are more likely to report high quality earnings, which are those derived from sustainable sources, such as genuine increases in sales or cost reductions, as opposed to temporary or manipulative factors.

Investors and acquirers analyze a company’s quality of earnings to obtain a more accurate picture of financial stability. Quality of earnings reports are often a standard part of the due diligence process for private acquisitions. These reports break down revenue sources into cash or non-cash as well as recurring or non-recurring income.

Because company income statements can lack essential details, breaking down cash sources can reveal discrepancies. For example, a company reporting high net income but negative operating cash flow might not be as financially stable as it first appears. Poor quality of earnings can signal increased investment risk and often influences acquisition decisions.

Differences between quality of earnings and net earnings

Net earnings, also referred to as net income, represents a company’s total profit after all expenses, taxes, interest, and other deductions have been subtracted. It appears on a company's income statement and serves as an indicator of profitability.

Quality of earnings refers to reliability and sustainability of reported net earnings. It assesses how accurately net earnings reflect a company’s core operations and whether they are influenced by one-time events, misstatements, or aggressive accounting practices. In short, it evaluates how much of a company's reported earnings are derived from genuine business performance.

While net earnings looks at how much profit a company made during a given period of time, quality of earnings is more focused on whether the earnings are reliable and indicative of future performance. Higher net earnings can attract investors and impact a company’s creditworthiness and stock valuation.

However, potential investors and buyers often look at quality of earnings to determine whether reported earnings are realistic and accurate. This information is then used to guide long-term investment decisions or mergers and acquisitions (M&A) valuations.

Why is quality of earnings important?

Quality of earnings is important as it assesses how accurately a company’s reported financial performance reflects its true financial condition.

Many companies use net income as a point of reference for their earnings. When net income is higher than the previous year or quarter, it’s considered to be a sign of success. However, net income can be influenced by accounting practices that distort the underlying financial reality. Quality of earnings analysis digs deeper to assess whether reported earnings truly reflect the company’s core operations.

When a company’s earnings are low quality, it may distort financial statements either by inflating earnings to appeal to analysts and investors or deflating them to reduce tax liabilities. These practices make it difficult for analysts, investors, and acquirers to assess the company’s actual performance and potential risk. Such companies are said to have poor quality earnings.

Because companies with high earnings quality are already financially stable, they are less likely to misrepresent earnings. These companies will typically adhere to GAAP standards that emphasize reliability and relevance:

• Reliability: Ensures that reported metrics are accurate, free from bias, and verifiable.
• Relevance: Ensures that financial information is timely and valuable for forecasting and decision-making.

That said, even companies with strong earnings quality may adjust financial reporting for tax planning purposes. While such adjustments are often legal and strategic, they can affect how earnings are presented.

Quality of earnings is important for investors as it reduces the uncertainty associated with financial analysis and makes it easier to compare companies or predict future performance. For companies, maintaining high earnings quality improves credibility and can enhance investor confidence.

What happens in a quality of earnings analysis?

A quality of earnings analysis examines different components of earnings to uncover potential issues and highlight areas of concern. This involves:

• Assessing the quality and accuracy of a company’s financial performance, focusing on historical trends and the strength of its earnings.
• Normalizing earnings, which involves excluding extraordinary and non-operational items to get a clearer picture of how the company would perform under ‘normal’ circumstances.

What does a quality of earnings analysis analyze?

A quality of earnings (QoE) analysis looks at three key components: adjusted EBITDA, proof of cash, and working capital.

Adjusted EBITDA

Adjusted EBITDA refers to earnings before interest, tax, depreciation, and amortization, adjusted to exclude non-recurring, extraordinary, or non-operational items. It ensures that reported earnings reflect sustainable operations rather than one-time events or accounting adjustments.

Adjustments to EBITDA might include:

• Identifying non-recurring expenses (e.g. one-time consulting fees)
• Normalizing for seasonality or significant business changes (e.g. major client losses or gains)
• Accounting for inefficiencies or cost-saving opportunities.

These adjustments aim to provide investors, buyers, or management, with a clearer understanding of the company’s earning potential.

Proof of cash

Proof of cash verifies that a company’s cash transactions match its reported income and expenses. This ensures that reported earnings are supported by actual cash flow, which is important when evaluating a company’s financial stability.

Working capital

Working capital – the difference between current assets and liabilities – provides insight into how a company manages its cash flow and daily operations. A quality of earnings analysis reviews working capital to evaluate how well a business manages its cash flow, assets, and liabilities, as well as highlighting any inefficiencies or areas of concern.

Similar to EBITDA adjustments, net working capital may be adjusted to better reflect a company’s true cash requirements. These adjustments can provide a clearer understanding of the company’s working capital requirements, assets, and operational efficiency.

Adjustments to working capital can account for factors like seasonal trends, errors in receivable reporting, outdated inventory, deferred revenue, and adjustments to accrued liabilities.

Common red flags to watch for in a company's financial statements

There are certain warning signs that may signal low quality of earnings. These include:

Aggressive accounting practices

Some companies use aggressive accounting to misrepresent earnings, either by inflating them before a transaction or suppressing them for tax benefits. These tactics can distort a company’s true financial performance and are often identified during a quality of earnings analysis.

Improper revenue recognition

Improper revenue recognition can be a result of complex accounting, inadequate accounting expertise, or intentional errors. Common examples include failing to record rebates, discounts, or product returns in the correct period. These errors can distort a company’s financial performance and affect key metrics used by investors and acquirers.

Improper capitalization of expenses

Capitalizing expenses that may not provide any future financial benefits can lead to understated expenses and an inflated financial position. This can obscure a company’s true operating expenses.

Non-GAAP accounting practices

Non-GAAP accounting practices involve presenting financial metrics that adjust or exclude certain items permitted under GAAP, such as restructuring costs or one-time charges. While these metrics can provide additional insight into a company’s core performance, excessive or inconsistent use can mislead investors.

Poor tracking of inventory and cost of goods sold (COGS)

Inaccurate inventory management impacts productivity and can distort COGS reporting. This could be due to a lax approach to business management, however it can also result from failing to record the cost of inventory, inflating vendor discounts, or even reporting non-existent inventory.

Related-party transactions

While some related-party transactions are legitimate, they can also be used to inflate income. For example, a company might ‘sell’ goods to a related entity or fictitious buyer to temporarily boost revenue, then cancel the transaction later.

Unreported or contingent liabilities

Liabilities such as bad debts, pending lawsuits, or damaged inventory that aren’t disclosed on financial statements may represent future obligations for a company.

Losing a large number of customers

Losing major customers can significantly affect a company’s revenue and may signal underlying issues like poor quality products or unsatisfactory customer service. These losses could have long-term repercussions for a business.

Disengaged management teams

Management that fails to regularly review or understand key financial reports opens the door for someone to distort revenue or misrepresent expenses. This may lead to inaccurate financial reporting and can indicate deeper operational problems.

Data discrepancies in financial records

With proper accounting, financial records should reconcile across all ledgers and statements. If there are mismatches, or transactions can’t be traced without gaps, more investigation needs to be done.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.