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?
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 Broken Down in Your 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 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 Conduct a Thorough Quality of Earnings Analysis
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:
- Scrutinize revenue streams for sustainability.
- Identify non-recurring, irregular expenses and gains.
- Assess accounting policies and estimates for aggressiveness.
- Analyze drivers and trends across reporting periods.
- Interview management on anomalies or significant activities.
- Isolate and quantify sustainable baseline earning power.
- Score quality and highlight risks factors discovered.
- Map quality issues to financial metrics impacted.
- Summarize key findings and normalize baseline projections.
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.
