Quality of Earnings Report
A company’s quality of earnings (“QOE”) can be determined a number of ways, but ultimately it is obtained through analysis of actual operating cash flow. Often this analysis leads to sales, and profit margins differ from internal financial statements and/or company tax returns.
To arrive at a true representation of operating sales and related expenses, we begin analysis with a high-level, key management and accounting staff interview in order to get a sense of day-to-day financial entry logistics, checks and balances in place, and leadership style overall.
In general, earnings that are calculated conservatively are considered more reliable than those calculated by aggressive tax mitigating accounting policies. Quality of earnings can be obscured by accounting practices that hide poor sales or increased business risk.
If a company adheres to generally accepted accounting principles (GAAP) and/or has audited financial records, it is likely that the quality of earnings is better presented and of higher quality when compared to a company that does not as stringently adhere to accounting principles.
One well known seminal financial scandal that could have been potentially avoided with a thorough quality of earnings analysis is Enron. In the case of Enron, the company was forcing customers to prepay for services which artificially inflated earnings mask to cover up operating problems.
Understanding Quality of Earnings
Some companies manipulate earnings downward to reduce the taxes they owe. Others find ways to artificially inflate earnings to make them look better to analysts and investors. Unveiling the true net income of a company narrows the gap between various manipulation techniques and operating profitability.
Companies that manipulate their earnings are said to have poor or low earnings quality and those that do not manipulate their earnings have a higher quality of earnings. However, many companies with high earnings quality will still adjust their financial information to minimize their tax burden. Identifying this type of manipulation is a key aspect to the work completed in a QOE report. One way in which the numbers are presently through a QOE analysis is through the identification of nonrecurring, non-operating, and/or discretionary sales and/or expenses.
As previously noted, there are many ways to gauge the quality of earnings. We often start at the top of the income statement and work our way down. As an example, companies that report a high growth in sales, may also show a corresponding growth in credit sales. Investors are wary of sales that are due only to lose credit terms. Or perhaps the subject company has taken on additional debt to repurchase shares and in doing so the company shares appear to be undervalued, when share value is falsely inflated.
QOE Value Drivers:
- A company’s quality of earnings can be revealed by spotting and removing any irregularities, accounting manipulation, or one-off accounting entries that skew the numbers.
- Questionable fraudulent activity is often identified through a QOE analysis (i.e., a reported increase in net income without the corresponding increase in cash flow).
- Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earnings (we often do an “audit check” in conjunction with this work using tracing to related bank entries).
A quality of earnings report is often an invaluable step in the acquisition and/or restructuring process. The expense to obtain this thorough analysis pales in comparison to the value that it provides.