Quality of Earnings Analysis

Quality of Earnings (QoE) Analysis is a crucial financial tool used by investors and potential buyers to evaluate the sustainability and accuracy of a company’s earnings. This process involves scrutinizing financial statements to identify the sources of income and ensuring that the reported profits are sustainable and not artificially inflated. QoE analysis helps to uncover any discrepancies, non-recurring items, or accounting practices that could distort a company’s true financial health.

 The scope of work and agreed upon procedures for any given QofE Analysis will depend on the size and characteristics of the target entity, and will typically include analyses to assess:

1. Earnings Sustainability: The primary goal of a Quality of Earnings analysis is to assess whether the company’s earnings are sustainable. Analysts examine recurring versus non-recurring revenues, and whether these earnings are derived from core operations or one-off events like asset sales.
2. Adjustment for Accounting Policies: Businesses may employ different accounting methods that can affect reported earnings. QoE analysis adjusts for practices such as revenue recognition, depreciation, and inventory methods, providing a clearer picture of the company’s financial standing.  For business using cash basis accounting, developing cash to accrual estimates and preparing revenue waterfalls to assess revenue cycle management is key.
3. Impact of One-Time Events: One-time events, such COVID relief funds, litigation costs, excess inventory purchases, or other non-recurring events can have a significant effect on earnings. A QoE analysis identifies these events and adjusts the earnings to reflect only ongoing operations.
4. Proforma Adjustments: QoE analysis will also work to carryforward recent changes and trending data to help investors understand the impact of these changes.  Typical examples include recent changes in commercial payor rates, annualizing the impact from the addition of new providers or services.

For investors, conducting a Quality of Earnings analysis ensures they aren’t misled by inflated or manipulated earnings reports. It provides a clearer understanding of a company’s profitability, growth potential, and operational risks. Moreover, this analysis is indispensable during mergers and acquisitions (M&A), as it helps the buyer understand whether the target company’s financial performance is reliable and accurately represented for establishing the purchase price.