Quality of Earnings Report: An Overview

If you are a company contemplating a merger or acquisition with another company, or you just want a better assessment of your financials, a Quality of Earnings (QoE) report could be your answer.

What is a Quality of Earnings Report?

A QoE report is a deep-dive assessment of a company’s financials, with emphasis on the sustainability and accuracy of earnings, identification of potential risks and opportunities, and the evaluation of operational efficiency.

Generally, a merger or acquisition will involve a QoE report conducted by a buyer to obtain a deeper understanding of the company’s earnings and cash flow by providing more information than what is found in financial statements. This information is crucial to buyers, so they know exactly what they are buying, and it’s also a critical element in finalizing a sales price and terms of any purchase/merger agreement.

Key Components of a Quality of Earnings Report May Include:

Sales/Revenue Analysis

The QofE process provides insights into the effectiveness of a company’s sales strategy, the demand for its products and/or services, and its overall profitability. Specifically, the revenue recognition, growth, concentration (customer and/or products) and the profitability of the revenue.

A sales analysis may include volume analysis, price analysis, sales mix analysis, and sales trend analysis, depending on the company and the industry.

Cost of Goods Sold (COGS) and Gross Margin Analysis

Understanding of the costs associated with generating the revenue (COGS analysis) and an evaluation of profitability of the revenue (gross margin) over a period of time.

In a COGS analysis, the process might: evaluate trends, the makeup of the costs, compare data against industry benchmarks, and inventory management.

In a gross margin analysis, the process might: analyze gross margin trends, compare against industry benchmarks, and analyze individual product or service margins.

Operating Expense Analysis

Review of the costs involved in the day-to-day operations of a business. It breaks down each type of operational expense to understand where money is being spent and how it impacts the company’s profitability. This information helps determine the predictability and scalability of a business.

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Identification of Non-Operating Income and Expenses

Companies can have income sources and expenses that are not continuing, necessary for the business to continue, and/or not directly related to its core business operations.

Examples of non-operating income sources include interest income, dividend income, gain on sale of assets, and foreign exchange gains.

Examples of non-operating expenses include interest expense, loss on sale of assets, impairment charges, foreign exchange losses, software implementation costs, charitable donations, and lawsuit settlements.

Working Capital Analysis

The core business needs operation capital to operate. This operating capital includes current assets such as cash, accounts receivable, inventory, and current obligations such as accounts payable, accrued liabilities, and short-term debt.

During a merger or purchase transaction, it is critical for a company to understand what is needed to operate the business. Having too much or too little working capital can result in a business needing to invest more into the business or overpay for excess working capital.

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Debt and Interest Expense Review

For mergers, an assessment of a company’s borrowed funds, the associated costs, and any potential risks associated with them may be necessary to evaluate.

Debt review includes debt structure, loan terms and conditions, debt covenants, and credit ratings.

Interest expense review includes interest rates, interest coverage ratio, capitalization of interest, and amortization of debt issuance costs.

Asset and Liability Review

An evaluation of a company’s tangible (i.e. accounts receivable, inventory, equipment, buildings, improvements) and intangible (i.e. goodwill, patterns, trademarks) assets, any potential overstated assets, undisclosed liabilities, or unrecorded items.

Liability evaluation includes accounts payable, accrued expenses, debt, deferred revenue, and provisions for liabilities.

Cash Flow Analysis

Evaluation of a company’s cash inflows and outflows, providing a detailed understanding of how a business generates and spends cash. This analysis provides management and investors with important information as it reveals a company’s ability to sustain operations, pay debts, and fund growth.

Earnings Normalization

This is the process used to adjust a company’s financial statements to remove non-recurring or irregular expenses to allow a more accurate view of a company's profitability.

Examples of non-recurring items include: on-time gains or losses, seasonal fluctuations, extraordinary items, changes in accounting principles, and effects of inflation or currency fluctuations.

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Economic Reality for Better Decision-Making

The goal of a quality of earnings report is to provide a detailed understanding of the economic reality of a company, which assists in better decision-making. It can be especially useful to buyers in M&A transactions as it helps in structuring the deal, setting the price, and identifying any potential red flags or deal breakers.

If you are interested in learning more details regarding quality of earnings reports or may be interested in having a report conducted on your business, please contact one of our accounting professionals.