Earnings get lots of attention, but not all earnings are of equal quality. If you are trying to raise money or sell your business, you’ll likely encounter a quality of earnings review.
What is a Quality of Earnings Review?
A Quality of Earnings Review (QE) is a routine part of due diligence. QE is most often performed by an accounting firm on behalf of the buyer/investor.
QE looks at details surrounding revenues, expenses, and net income to determine the accuracy of your business’s financial results. QE also seeks to evaluate whether previous results can be sustained and if future projections are achievable.
Buyers/investors are willing to pay more for high QE companies because higher quality = lower investment risk.
Deloitte describes 3 spectrums that influence earnings quality:
1. Cash vs. Non-Cash
2. Recurring or Non-Recurring
3. Degree of estimation
P&L earnings that represent recurring, predictable cash are more desirable than non-recurring, paper earnings based on estimates.
Professionals performing QE try to answer questions such as (this is a partial list):
1. Do sales increases result from business improvements or things like loosening of credit terms or inflation?
2. Is there a large difference between net income and operating cash flow?
3. Do sales result in cash? How long is the cash collection cycle?
4. Does the company have high AR write-offs? Are AR write-offs trending up or down?
5. Are any costs not accrued?
6. When expenses are categorized as “one-time expenses,” are they actually more frequent?
7. Do company estimates stay consistent or do they frequently change?
QE conclusions are compiled into a report and presented to the prospective buyer/investor. The report is used to help decide whether or not to invest, and at what price.