What Is Quality of Earnings (QofE)

Quality of earnings (QofE) is the proportion of a company’s income that can be attributed to increased sales or operational values. Thus, quality of earnings refers to the actual income a company generates.

Meanwhile, a quality of earnings report is a deep dive into a company’s financial statements to determine the accuracy and quality of its historical earnings and assets. It is a form of due diligence and may be requested or even required when a company wishes to buy or sell.

While an audit is the what, a QofE is the why. An audit discusses what is on the financial statements and their accuracy, while a QofE discusses why there are specific numbers on the financial statements and tell the story. 

What Is Included in a Quality of Earnings Report?

A quality of earnings report is usually formatted with the following core features:

  • Executive Summary: The executive summary includes information regarding the company background, systems, and accounting department, as well as an overview of key findings and other items.
  • Quality of Earnings (EBITDA): This is the meat of the report. It’s an overview of your net income compared to earnings before interest, taxes, depreciation, and amortization (EBITDA). This section discusses normalization adjustments, such as management-proposed adjustments, diligence adjustments, and other considerations. 
  • Financial Statements: This section analyzes the income statement and balance sheet. It includes an income statement analysis, including the percent of total sales and year-over-year fluctuations. The balance sheet analysis discusses current assets, liabilities, and other details like long-term debt. Details like purchase price allocations may be calculated in this phase when the business considers its potential sale.
  • Financial Performance: This section covers items such as proof of cash—which compares the cash deposits recorded in the bank statements to the cash collections reported in the financial statements—sales by top products, revenue by customer/channel, and vendor concentration. 
  • Working Capital: This section discusses trends and unusual fluctuations surrounding working capital. It also identifies key ratios that are necessary to establish a “peg” amount for purchase price adjustment purposes. Some of those key ratios include DSO (days sales outstanding), DPO (days payable outstanding), DIO/DOH (days inventory outstanding, or days of inventory on hand), and inventory turnover ratio. 
  • Appendices: This section includes the scope of processes, as well as the monthly adjustments made to EBITDA. 

Difference Between Sell-Side and Buy-Side QofE Report

Sell-side QofE means the report was requested by the company wishing to be purchased. Meanwhile, buy-side QofE means the purchasing company requested the report.

As a seller, we always want to know how a buyer will see our financials when performing a QofE. We want to prepare now for those discussions and not be surprised in any way.

As a buyer, we want to be able to argue for a fair valuation if we discover something that alters our initial view of the company’s earnings. Again, we don’t want any surprises.

Why Is Quality of Earnings Important?

Shareholders of your company want to see high-quality earnings, as it can attract more investors and produce higher stock prices. Quality of earnings is also indicative for potential buyers of your company. If you wish to sell or merge with another company, your quality of earnings can give interested parties a general idea of your company’s financial well-being.

What Are the Benefits of Quality of Earnings Reports?

There are several advantages you stand to gain from a QofE report:

  • Identifies necessary adjustments to EBITDA
  • Compares cash deposits to reported revenue to accurately reflect true cash performance
  • Addresses and helps resolve possible accounting issues
  • Establishes credibility to a company’s financials, creating confidence from a buyer’s perspective
  • Fosters more efficient transactions

How Is Quality of Earnings Measured?

Quality of earnings is measured using several factors from your financial statements. These include:

  • Income statements
  • Net income
  • Sales growth
  • Credit sales
  • Accounts receivable
  • Current cash flow
  • Any one-time adjustments to net income

Many financiers will dissect every detail in an annual report to determine the quality of earnings, but the above factors provide an adequate baseline.

What Are Low-Quality Earnings?

A company has low-quality earnings if its income is insufficient to cover the company’s cost of capital. If the company has sufficient income derived from non-recurring, one-off payments, that is also considered low-quality earnings. 

Low-quality earnings may also be used to describe financial information that does not provide useful context for the company’s financial performance.

When Is a Quality of Earnings Report Required?

A quality of earnings report is usually required before a company begins to solicit buyers for an acquisition. This ensures that any potential problems that may disrupt the sale are uncovered before getting too far into the process.

When Should I Get a Quality of Earnings Report?

The time required to complete a QofE report is not extensive—it generally takes between 4–8 weeks. But it’s best to be proactive when getting your QofE report. The earlier you start the process, the quicker you can identify what needs to be addressed and what the buyer will see about your company. 

For sell-side QofE reports, it’s easier to plan ahead because the company has plenty of time to prepare. It’s not uncommon for these companies to complete their report 12 months prior to the final transaction.

For buy-side QofE reports, you want there to be enough time to argue for a fair valuation before you go too far into the deal. As such, you should request a QofE report as soon as you start to consider buying a company.

In short, the insights from a QofE report can never be gained too early as they will guide every decision you need to make during the transaction. 

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