Experienced business managers know that flashy earnings reports don’t always reflect operational realities. A quality of earnings report is vital for companies seeking to understand their true financial health and long-term viability, especially as they gear up to sell their business or seek investors.
What Is a Quality of Earnings Report and Why Is It Important?
A quality of earnings report is an analysis that evaluates the consistency and reliability of a company’s reported income over multi-year periods by adjusting for the impact of non-recurring, irregular or non-cash items on earnings.
A quality of earnings analysis is often conducted during an M&A, investment decision or accounting due diligence. Therefore, businesses need a quality of earnings report that provides critical insights into the drivers of profitability and reliable indicators of future performance.
The hallmarks of high-quality sustainable earnings are profits generated from stable recurring revenue streams, backed by solid operating cash flows. Low quality earnings may come from excessive one-time gains, aggressive revenue recognition or cuts that damage long-term health.
The Key Components of a Quality of Earnings Report
There are many potential components of this report, but the most common and essential components include:
- Financial statement analysis: This component includes a thorough review of the income statement, balance sheet and cash flow statement. The aim is to validate the accuracy of these statements and identify any irregularities or non-recurring items that might skew a company’s true financial performance.
- EBITDA analysis: A critical element in assessing a company’s operational profitability, an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) analysis involves stripping out the effects of financing and accounting decisions to focus on the core operating results and compare profitability across industry peers.
- Revenue quality and sustainability: This aspect evaluates the consistency and reliability of revenue streams. It includes assessing whether revenues are recurring or one-time, the diversification of revenue sources and any risks associated with customer concentration.
- Working capital analysis: Here, the focus is on understanding the company’s operational liquidity. This involves examining accounts receivable, inventory, and accounts payable to assess how efficiently the company manages its short-term assets and liabilities.
Why a Quality of Earnings Analysis Is Vital to a Transaction and Beyond
A robust quality of earnings analysis is vital when buying or selling whole businesses. For acquirers, it helps avoid overpaying by revealing risks that undermine the accuracy of performance projections. It can also uncover aggressive accounting practices. For sellers, demonstrating consistent income drivers provides assurance around expected valuation and shareholders’ returns.
A quality of earnings report can also aid the development of accurate forecasting models by identifying a company’s reliable profit drivers and highlighting risks that can be baked into scenario or sensitivity analyses.
A Quality of Earnings Review Is Not an Audit
While both examine a company’s finances, a quality of earnings review and a financial statement audit have different focuses:
- A financial audit verifies whether a company’s accounting statements conform to GAAP standards through sampling transactions. A quality of earnings analysis complements this by assessing earnings sustainability and sources in greater depth.
- Audits ensure numerical accuracy and compliance. A quality of earnings review includes quantitative modeling but also qualitative factors like management integrity affecting earnings consistency.
- Audits check that past numbers are free from material misstatements. A quality of earnings analysis evaluates future profitability drivers to inform planning.
- Financial audits are conducted annually. A review of quality earnings is done less frequently but provides additional insight into a company’s changing risk exposures.
How To Prepare a Quality of Earnings Report: An Example
Producing a rigorous quality of earnings report—the kind a business needs to safeguard a potentially significant investment—requires the expertise of trained professionals who can perform both quantitative financial modeling and a qualitative review of accounting practices. This is often conducted by objective, third-party accounting professionals.
An expert will take the following steps to analyze earnings quality:
Step 1: Scrutinize the Company’s Revenue Streams
Your analyst will examine where, how and from whom revenue flows into the company in order to identify potential risks.
- If too much of the company’s revenue comes from a single customer, the company will suffer a significant loss if that customer were to disappear.
- A widespread customer base offers more sustainable income potential and builds resilience.
Step 2: Identify Non-Recurring, Irregular Expenses and Gains
Your expert will distinguish between ongoing and regular expenses and revenue.
- A single large expense, such as the purchase of manufacturing equipment, might affect a single financial statement but offer increased earning potential going forward.
- A single large sale might significantly boost a company’s revenue, but if it is not replicable, it cannot be considered a reliable part of the company’s regular revenue stream.
Step 3: Assess Accounting Policies and Estimates for Aggressiveness
Aggressive accounting practices overstate a company’s financial standing. Here are a few ways a company might misrepresent their financial performance in order to be more attractive to potential buyers:
- Asset inflation
- Early revenue recognition
- Exaggerated inventory reserves
- Expense deferrals
Step 4: Analyze Drivers and Trends Across Reporting Periods
As part of the deep-dive analysis, your expert will examine key drivers and trends to generate a thorough understanding of sales patterns and rhythms over time, including:
- Assessing which of the company’s divisions generate the most consistent revenue and on what timelines.
- Determining whether growth stems from organic sales or from increased sales on credit.
- Investigating the extent to which earnings might be linked to external forces such as higher commodity prices.
Step 5: Interview Management About Anomalies or Significant Activities
Numbers are only the first part of the full financial story. As part of their qualitative examination, your expert will assess management’s achievements and behaviors to determine what, if any, effect they have on accounting strategies or revenue generation. They might ask about:
- Any revenue spikes (such as asset sales) or fluctuations in expenses (such as restructuring costs) to determine whether they are anomalous or likely to recur.
- Changes in accounting procedures and whether they reflect genuine business evolution or are attempts to manage earnings.
- Operational challenges, strategic shifts or competitive risks that could affect future earnings.
Step 6: Isolate and Quantify Sustainable Baseline Earning Power
In any company, some product lines and service offerings will bring in more revenue than others. Your quality of earnings analyst will uncover which products and offerings are most important to future performance.
- Consistent sales across multiple offerings demonstrate resilience.
- Overreliance on a single product offering might lead to difficulty if the market shifts.
Step 7: Summarize and Report Findings
After collecting and examining all the information, your analyst will summarize their findings. They’ll prepare a report providing a comprehensive view of the company’s financial situation, not only assessing the accuracy of their numbers but also evaluating the inherent quality of their revenue. A typical quality of earnings report will include summaries that:
- Rank and score the earnings qualities revealed during the analysis.
- Map the earnings qualities to the appropriate financial metrics.
- Highlight and explain any risk factors and outline potential impacts.
Tap Into Experienced Fractional Expertise to Support Reporting
Don’t let the complexities of financial analysis hold you back. Whether you need a comprehensive report for a potential acquisition or you want to gain deeper insights into your own company’s financial health, Paro’s fractional accounting experts are here to guide you. Our network of vetted experts is available on-demand to support one-time reporting needs or ongoing needs based on your goals. Schedule a free consultation to learn how we can help.
