What Is A Quality Of Earnings Report (QOE)?

Acquiring or investing in a new company can be an exciting yet risky process. How do you know that the information in the company’s balance sheet and income statement accurately reflects the target company’s financial position?

The financial due diligence process can help you answer this question. That’s why it’s one of the most important parts of any private acquisition, providing valuable insights into the target company’s financial performance.

The quality of earnings report (QOE) is an essential part of accounting due diligence, as it resolves any uncertainties behind the earnings quality of a company. Let us walk you through the accounting principles of a QOE report.

Quality Of Earnings Report 101

A QOE report gives a clear, detailed look into a company's financial health beyond basic numbers. It digs deep into the “why” the numbers in a business’s income statement look the way they do. This can help potential buyers make more informed decisions. Here’s the 101 on this staple of quality finance reporting.

Definition Of A Quality Of Earnings Report

A QOE report is a financial analysis that takes a closer look at how a company makes money. It is typically performed by a third-party financial expert who looks at the sources of revenue for a company, such as cash and non-cash earnings.

It’s like a health check-up for a company’s finances, helping to spot any issues that might not be obvious at first glance.

This ensures investors or buyers know exactly what they’re getting into, making QOE reports essential parts of the due diligence process to ensure a smooth investment or acquisition.

Purpose And Importance Of QOE In Financial Analysis

The first letter of the acronym tells you the main purpose of this report, with the Q in QOE meaning “quality.”

This report helps investors understand the true nature of a company’s earnings, identifying risks or opportunities that may not be easy to see in regular financial statements.

For example, a one-time cash payment could inflate a company’s financial performance in a specific year or quarter. It may make it seem like the company’s profit margins are higher than they actually are or that its year-on-year (YoY) growth is impressive.

However, a QOE report will uncover any such scenarios, helping investors spot any potential cash flow problems and more accurately anticipate future economic earnings. It reduces the risk of unpleasant surprises after an investment or acquisition, making financial outcomes more predictable.

Components Of A Quality Of Earnings Report

A QOE analysis differs from other financial reports as it has a very specific goal in mind: understanding how a business makes money. Here are some of the key components that you may find in a quality of earnings report template.

1. Revenue Analysis

This section scrutinizes where the company's money comes from. It distinguishes between regular income streams and those unlikely to recur, like a one-off sale of a major asset.

2. Expense Evaluation

Here, the focus is on what it costs to run the company. This includes separating everyday operating expenses from extraordinary ones, such as costs from a lawsuit or a major equipment overhaul.

3. Earnings Quality

This part examines the trustworthiness of reported earnings. It looks at cash flow versus earnings reported on the income statement to verify that earnings are not just paper profits but are backed by cash.

4. Working Capital Analysis

Assesses the company's ability to cover short-term liabilities with short-term assets, ensuring it can meet its immediate financial needs. Inadequate capital could signal liquidity problems in the short term.

5. Debt And Liabilities Review

This dives into the company’s debt and financial obligations to measure the company’s leverage and risk of default. Unsustainable debt could complicate everyday operations in the future.

6. Projections And Forecasts

Provides an outlook on the company’s future earnings, considering historical performance, industry trends, and current financial health. This is one of the most important parts of the report, as it offers a judgment on the company’s future financial performance.

How A QOE Differs From Standard Financial Statements

You might be wondering how a QOE report differs from an audit. In essence, an audit is designed to confirm the numbers in a company’s financial statements and accounting quality. They evaluate income statements against bank statements and other documents to confirm that they were created according to U.S. Generally Accepted Accounting Principles (U.S. GAAP). A QOE report, rather than corroborating the accuracy of the documents, will look at the sources of the revenue to identify potential issues.

Here are some of the things you can expect from a quality of earnings report vs. audit.

Depth Of Analysis

A QOE report delves into income sources, examining whether earnings are recurring or one-time. An audit simply aims to verify the accuracy of financial statements by checking for compliance with accounting standards.

Adjustments

QOE reports include adjustments for unusual, non-recurring, or one-off items that might distort the true financial performance. An audit concentrates on whether financial statements are free from errors. Adjustments aren’t made for analytical purposes but to correct mistakes.

Focus On Cash Flow

In addition to earnings, a QOE report emphasizes the quality of cash flow, differentiating between cash earned through core business activities and that from financing or investing activities. Audits only review cash flow statements for accuracy.

Future Earnings Potential

QOE reports assess the sustainability of earnings, analyzing factors that could affect future performance. Audits don’t evaluate future earning potential at all.

Comprehensive Business Analysis

Beyond numbers, a QOE report often includes a review of market position, competitive landscape, customer base, and supplier relationships. Audits don’t provide a comprehensive business analysis.

The Process Of Conducting A QOE Analysis

Conducting a QOE analysis report is a surefire way to get closely acquainted with a company’s financial health.

If you’ve ever bought a used car, you may already know that you should watch out for “lemons.” Lemons are cars with manufacturing defects or maintenance problems that make them unfit for use and cannot be easily or reasonably repaired.

Unfortunately, many such defects aren’t apparent to the average consumer. Taking a used car to an independent mechanic before signing the dotted line can help you ensure that the car you’re buying isn’t a lemon.

Conducting a QOE analysis before investing in or acquiring a business offers the same type of protection.

To do this, the QOE report process involves several critical steps:

1. Define The Purpose And Gather Information

The first step in conducting a QOE analysis is to clearly define its purpose.

Are you a potential buyer evaluating a future acquisition? Are you assessing the health of your business for a future sale?

With the right goal in mind, the next task is gathering financial data, operational metrics, and market information.

This includes financial statements, tax returns, and details on revenue streams, expenses, retained earnings, cash flow, and calculations like EBITDA or EBIT. If you don’t know what EBIT is, it’s worth noting that it’s not a U.S. GAAP financial measure, but it can be a helpful way to assess a company’s profitability.

2. Adjust Earnings

Adjusting the earnings means normalizing earnings to remove any one-time, non-recurring, or extraordinary items.

This helps identify the company's sustainable earnings by excluding those that don't reflect normal business operations. Adjustments may include removing unusual sales, expenses, or events.

For example, a company may rightfully claim to have generated $10 million in revenue during the previous fiscal year. It may also rightfully claim that this was a YoY increase in revenue of 100%.

At first glance, these numbers seem incredible. Business is booming!

However, a QOE analysis will ask how the business achieved these earnings. The business could have experienced a sustained decline in monthly revenue with a one-off sale that inflated its yearly revenue. This would paint a less-than-stellar picture, as you can’t say that the business will make similar sales regularly.

3. Identify Red Flags

Identifying red flags involves scrutinizing the adjusted earnings for inconsistencies, unusual trends, or anomalies in revenue recognition, expense management, or cash flow patterns.

A QOE report analyzes large, one-time sales or expenses that significantly impact earnings. It also explores whether the company is reliant on a few customers or if there are any signs of declining customer relationships. A significant backlog of maintenance or capital expenditures could also signify financial problems down the road.

4. Evaluate Sustainability

Evaluating sustainability involves analyzing whether the company's earnings are likely to continue at the current level into the future. This step assesses the stability and quality of revenue streams, cost control measures, market position, competitive advantages, and industry trends. It's about understanding what drives earnings and whether they are reliable over the long term.

5. Document Your Findings And Interpret The Impact

The final step in the QOE process is to document your findings and analyze. This involves compiling the adjusted earnings, identified red flags, and sustainability analysis into a comprehensive report.

The report should clearly present the findings, explain the adjustments made, detail any concerns, and discuss the company's future earnings potential. It should end with actionable insight for decision-makers.

Leverage The Value Of QOE Reports In Business Decision-Making

When buying a business, knowing its true financial health is key. This is where QOE reports shine. They dive deep, looking at how a company really makes money and spends it.

By checking if earnings are steady and spotting any financial red flags, these reports help you see the full picture. They make the complex simple, guiding you to invest wisely.

Because they’re such an important part of the due diligence process, it’s always best to speak with a professional to discuss your reporting needs. An AI-powered accounting software and an expert financial team can help you make the best business decisions for you and your team.