Stripping the superfluous; Quality of Earnings (QoE) analysis gets to the heart of operational performance
It’s been said that the “devil is in the details.” A type of report known as a “Quality of Earnings Analysis,” is a unique animal. To get to the heart or quality of your business’s earnings, you have to strip out the ancillary details or internal or external factors that can detract from the “real” performance of your business. In this manner, you (and any parties that request this information) are provided with an accurate, honest, objective, and detailed look into what your company has actually earned.
Putting the “quality” into the earnings analysis
A Quality of Earnings Analysis also strips out any abnormalities that may have occurred on a one-time basis, which can send the bottom-line numbers askew. By removing the misleading or superfluous “details” over the course of the earnings analysis, you can arrive at real, “naked” earnings derived from greater sales or lower expenses. So, the QoE reflects that percentage of income that is tied to genuine earnings “drivers.”
Internal factors that are stripped out during analysis:
Earnings calculated with aggressive accounting policies
Examples of aggressive accounting policies or practices may overstate income, or understate costs to disguise poor sales or heightened business risks
Assets, for instance, may be inflated by overstating the overhead applied to inventory and, in turn, enhancing the value of a company’s current assets
Revenue may be enhanced with techniques such as recording sales before they are finalized (to capture those earnings earlier)
Management-related decisions regarding operations
External factors that are stripped out during analysis:
Periods of high inflation
Business climate
Industry- and sector-specific trends
Society-altering effects *
Generally, the more companies and accounting partners stick to GAAP, the higher the quality of its earnings analysis. These Generally Accepted Accounting Principles are issued by the Financial Accounting Standards Board. The standards reflect widely accepted ways to record and report accounting information. They facilitate clear and reliable communication of financial info.
The ABC’s of QoE
As referenced, there are “best practices,” to adhere to, assuring earnings are of high quality. It’s typical to start analysis at the pinnacle of the income statement, working one’s way down. In fact, a good measure that earnings analysis is of high quality is to track activity from the income statement to the cash flow statement and balance sheet
In other words, as accounting partners, we’d find and report high sales growth and high credit sales growth, trends that make sense (analysis is suspect if sales are reflected only with “loose credit terms,” changes found in balance sheets and cash flow statements). Those parties who are analyzing your earnings will be on the look-out for variances between the likes of cash flow and net income.
Alternately, red flags might include:
Increases in net income that don’t correspond with spikes in cash flow
Companies with high net incomes and negative cash flows (they are achieving earnings somewhere other than sales)
One-time adjustments to net income (nonrecurring income or expenses); for instance, companies decrease expenses by refinancing debt into balloon payments, which kicks the repayment “can” down the road
Earnings manipulation, such as buying back shares of one’s own stock
Why QoE matters
Some of the most alarming examples, which demonstrate the importance of rendering quality earnings, include scandals that are now household names: WorldCom and Enron. These are applicable, albeit dramatic, instances of aggressive accounting. The late 1990s was rife for “cooking the books,” companies knowingly engaging in falsifying financial statements to mislead investors.
If a business reports positive net income but lackluster earnings, it would be a risky investment for an acquiring company. So, as a breakdown of cash sources – key details not outlined within income statements – the quality earnings provide insight for an acquirer that can’t be provided within the financial statements. This “quality” analysis is also considered to be a vital part of the buying or selling process as a whole. It fits within the notion of doing one’s due diligence. In fact, these details are such a vital component of the process that, if you’re a seller, QoE is referenced as a “sell-side” quality of earnings report. If you’re the buyer or investor, it’s referred to as a “buy-side” QoE analysis.
Regardless of what you may call it, we can’t overstate the insight that this information provides into the impact of activities or indicators that don’t reflect the actual performance or cash flow of the business. Effectively, those items that are not able to be repeated (or sustained) and are tied to some of the external and internal factors listed above, are clearly isolated. That way, nothing gets in the way of management and your partners getting an accurate picture of your sales and costs. It also provides substantive knowledge about those factors that can be “clouding” that picture. By separating these details out, you gain considerable strategy- and decision-making intelligence.
The implications of the QoE are also closely linked to your “why”: What motivated that such a report be requested in the first place? These motivations can differ greatly from client to client, and across the “life” of the business. For instance, while the report isn’t an official valuation per se (although we do have accredited business valuation professionals on staff!), it does help to get closer to that magic number. Again, QoE provide invaluable insight to both the buyer and investor (as well as the seller) related to a realistic and fair value. The report does so by providing analyses and reportage into those details that aren’t at-the-ready. This information can then be taken into account during deal structures and negotiations. The dreaded “remorse” buyers or sellers may feel by either overpaying or underselling is also minimized by reducing the risks associated with an inaccurate picture of the company’s real value.
Furthermore, the QoE differs from other bread and butter financial documentation, such as a financial statement, by wrapping its arms around indicators of sustainable, long-term business performance at a detailed level. Another way of looking at QoE is that such analysis looks toward the future. Financial statements, for instance, are inherently retrospective rather than prospective. The goal of those audits or reviews is to provide assurance that your business’s financials conform to the aforementioned GAAP. So, it’s a “must” to conforming to generally accepted from a compliance perspective.
QoE is demonstrative of the capacity for the business to continue to perform exceptionally, well into the future. It is not as caught up with identifying the complete and accurate “numbers” related to past performance. Rather, QoE is more concerned about identifying the drivers behind those numbers to get an accurate sense into how the company is positioned into the future and its “earnings power” over the long term.
For more details about Quality of Earnings analysis and any other tax, accounting, assurance, and business support needs, contact Justice Coffey at O’Donnell, Ficenec, Wills & Ferdig #OFWF. We have been partnering with Omaha-area organizations on these and other financial and operational matters for 70 years.