What is the Quality of Earnings Report?
The Quality of Earnings (QoE) report provides a thorough analysis of a company’s earnings by separating sustainable, recurring revenue from one-time or irregular events that might distort the financial performance.
It is not a valuation estimate but a supporting document that clarifies financial statements by removing anomalies and focusing on consistent earnings.
Net Income does not necessarily represent the complete picture of a company's financial performance. For that reason, these adjustments ensure that the earnings reported reflect the company's true operational performance rather than being skewed by non-recurring items.
Selling a business is inherently stressful, and buyers will be hesitant unless they are confident that the financial performance is accurate and free from unexpected issues.
The QoE report is essential for sellers because it helps identify potential financial concerns before the sale, allowing sellers to address these issues and present more reliable financials.
This approach can lead to a smoother due diligence process and potentially a higher valuation, as buyers are more likely to trust and value high-quality earnings.
- Quality of Earnings report is a crucial aspect of acquisition due diligence, evaluating a target company’s financial health.
- An increase in net income without a corresponding increase in cash flow from operations is a bad sign. The quality of earnings would definitely be lower, or at the very least, needs to be investigated further.
- Tracking the company’s activity from the income statement and flowing it through the balance sheet and cash flow statement is a very common and accurate way to gauge the quality of earnings.
- The independent 3rd party advisory, financial, accounting, or consulting firms push the Quality of Earnings report. They are the ones that will mediate earnings quality unbiasedly for both the sell and buy sides.
Sell-Side QoE
- Concerns and Solutions: It helps sellers identify and address potential issues before entering negotiations. For example, if the report reveals that recent earnings were inflated due to a temporary decrease in operating costs, sellers can adjust their financials accordingly before presenting them to buyers.
- Higher Valuation: By showcasing higher-quality earnings, sellers can expedite the due diligence process and potentially secure a higher valuation for their business.
Buy-Side QoE
- Greater Certainty: It provides acquirers with a clearer understanding of the target company's financials, helping them assess the true earning potential and reduce the risk of unforeseen issues. For instance, if the report identifies that a one-time event significantly boosts earnings, buyers can adjust their valuation accordingly.
- Risk Reduction: By understanding the quality of earnings, buyers can align their investment expectations with the company’s true financial performance, ensuring that the purchase price reflects the actual risk and return.
In real-world scenarios, external factors during periods of high inflation can affect the quality of earnings since sales figures could be inflated. The QoE report adjusts for these external factors to provide a more accurate picture of the company’s sustainable earnings, ensuring that the reported financials are not misleading due to economic distortions.
Generally, in finance, earnings that are calculated conservatively would be higher quality earnings than aggressive, more idealistic earnings.
General accepted accounting principles (GAAP) is an accounting standard that companies stick to to ensure a higher quality of earnings.
Understanding Quality of Earnings Report
QoE reports seek to:
- Dismiss anomalous earnings
- Account for transaction tricks
- Make considerations for one-time events
The three types of factors that affect the quality of earnings are accounting factors, external factors, and operational factors.
Accounting Factors
Companies can manipulate earnings downwards to reduce the taxes they owe. On the other side of the same coin, they could also find ways to inflate earnings upwards to appease investors or analysts.
Examples of accounting factors for the quality of earnings reports:
- Refinancing all current debt into future payments reduces the current expense. This would look like lower debt expenses in the short run and an increased net income.
- Large non-recurring incomes or expenses would inflate or deflate the net income significantly.
- Sales that are due to credit would increase account payables on balance sheets and cash flow statements. Once the bank settles with cash, accounts receivables will go down, and cash will go up.
- PP&E might be depreciated aggressively to reduce EBIT and reduce taxes paid.
- Other variations between cash flow from operating activities and net income. If a company has high net income but negative cash flow from operations to achieve the bottom line, that is a red flag.
External Factors
External factors are macro events that heavily influence revenues and the bottom line. The reality is that markets change all the time and their implications on business over time are unignorable.
Examples of external factors for the quality of earnings reports:
- Inflation
- Rapid expansion or contraction of the nation where business is conducted
- Politics and geopolitical events
- One-time changes in consumer behavior
- Meteorology
- Trends that are not likely going to be popular in the future
Operational Factors
Operational factors are any risks that the business assumes on a product or service level. For example, SRU.UN is a real estate investment trust that only has a few clients who make up an outstanding majority of all of its revenues.
One of those clients is Walmart, so if anything were to happen to Walmart, SRU.UN would be impacted in a big way.
Examples of operational factors for the quality of earnings reports:
- Specific clients and their level of risk
- Industry trends and risks
- Product lines or services’ economics
- Product trends
- Other specific relevant metrics
Example of Quality of Earnings Report
Quality of Earning reports aren’t too standardized or complicated compared to other deliverables because they are effectively documents with commentary. An external 3rd party will do an unbiased quality of earnings analysis and submit their findings.
For this example specifically, let us assume that ABC Corp is a pizza company and is the target company of Rock Capital. Rock Capital wants to acquire ABC for its unique partnerships and its fixed assets.
DEF Advisors is the 3rd party that will create the Quality of Earnings report. XYZ is the sell-side investment bank that hired DEF Advisors.
The layout of the Quality of Earnings report looks like this:
| Executive Summary
|
| Income Statement
|
| Balance Sheet
|
The most important section of the entire document is anything with “Issues & Recommendations”. The Issues & Recommendations would look something similar to this:
| Income Statement | Observation | Recommendation |
|---|---|---|
| Revenue and Uber Eats | ABC has a few large branch locations. However, in 2012, ABC partnered up with Uber Eats for more discounted pizza than usual. | Although this Uber Eats partnership is unusual due to ABC’s small size, ABC can take advantage of the large volume style sales from Uber Eats. XYZ should follow similar patterns with more established chains like Domino’s Pizza in terms of the leveraging of many pizza discounts. |
| DEF Advisors reviewed revenues for XYZ if any large non-recurring items occurred to XYZ. DEF noted that while there was no large non-recurring item, an interesting pattern emerged with the Uber Eats partnership. Revenues increased, but margins on these Uber Eats sales remained low. |
| Balance Sheet | Observation | Recommendation |
|---|---|---|
| Purchase price allocation | ABC should reorganize as much of the purchase price as possible to tangible assets to write off fixed assets for tax purposes. DEF estimates that the value of the tax shield would increase by $100 if an additional $1,000 of value were reallocated to tangible assets. | ABC should determine the fair market value of the assets to be purchased and negotiate for maximum value to tangible assets. This will increase the tax shield. |
The 3rd party consultants for Quality of Earnings could also comment on normalizing earnings, addressing payroll inefficiencies, implementing new IT systems, and new methods of inventory management.
Evaluating the Quality of Earnings Report
There are a few considerations regarding whether earnings are higher or lower quality and higher or lower risk.
Likely recurring cash transactions are usually of the highest quality and lowest risk. Cash transitions that might not occur again are lower quality and higher risk.
Non-recurring no-cash transactions are even lower in quality and higher in risk.
For the company’s financial statements, there should be some sort of consistency in:
- Accounting principles
- Degree of estimation in financial statements
- Transparency of financials and footnotes
- Management decisions and analysis (MD&A)
- Net income to operating cash flow ratio
Operating cash flow is not the only denominator for the net income to operating cash flow ratio. For operating cash flow, professionals often use earnings before interests, taxes, depreciation, and amortization (EBITDA) as a proxy for cash flow which is representative of the entire enterprise.
For quality of earnings, the independent 3rd party will often take a step further and present their own adjusted EBITDA. The adjusted EBITDA is the cash flow the 3rd party believes is the sell side’s most true cash flow from operations metric.
Undoubtedly, the most common adjustment to EBITDA is the exclusion of non-operating activities, which the independent 3rd party will have to defend to both the sell-side and buy-side.
Both the buy-side and sell-side can challenge any non-operating items by carefully dissecting the target company’s PnL and balance sheet.
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