Quality of Earnings Analysis

Investment Banking Interview Prep: Earnings Quality Explained (Cheatsheet) 🏆 What is Earnings Quality? Earnings quality refers to how reliable a company’s reported earnings are as indicators of current performance and predictors of future performance. High-quality earnings are typically free from manipulation, reflect the underlying economics of the business, and are more likely to be sustainable over time. There’s no single formula to assess earnings quality. Instead, it requires a combination of techniques, including in-depth financial statement analysis to identify: • Non-recurring items • Significant non-cash items • Balance sheet elements subject to management discretion Common Metrics Used to Assess Earnings Quality: Cash Conversion Ratio: Measures the amount of cash generated for every dollar of reported earnings. Accruals Ratio: Compares accruals on the balance sheet to total operating assets. A high cash conversion ratio and a low accruals ratio typically indicate high earnings quality. A low cash conversion ratio and a high accruals ratio typically indicate low earnings quality. How Is It Measured? There’s no universal method, but key red flags in the financials can suggest lower quality earnings. Look for: • Non-recurring items: e.g., impairment charges, gains on asset sales • Non-cash items: e.g., revaluations, provision releases • Estimates and judgments: e.g., inventory valuation, accrued liabilities Quantitative Metrics: • Cash Conversion Ratio = Operating Cash Flow / EBITDA • Accruals Ratio = (Net Income – Operating CF – Investing CF) / Avg. (Total Assets – Cash & Equivalents) Why Does It Matter? Earnings quality underpins forward-looking analysis. Low-quality earnings may inflate current performance, but signal weaker future cash flows, impacting debt capacity estimates and company valuations. Earnings quality assessment is essential in: • Credit analysis (for lending or deal structuring) • Due diligence (for M&A, LBOs, IPOs) • Valuation work (equity or credit research) Key Learning Points: • Earnings quality is used to determine whether a company’s earnings provide a reliable measure of a company’s current performance and are a good predictor of future performance • There is no single measure of earnings quality, but the cash conversion ratio and the accruals ratio are widely used metrics. • A high cash conversion and a low accruals ratio are indicators of high earnings quality and vice versa • Earnings quality drives expectations of future cash flow. It is, therefore, a key technique in credit analysis, deal due diligence (M&A and LBOs), and investment research • Low earnings quality can provide evidence of earnings manipulation by management - it may therefore be used in corporate governance analysis Want to learn more? Financial Edge Training 🏆 https://shorturl.at/6POdF

💡 𝐈𝐧𝐬𝐢𝐝𝐞 𝐌&𝐀 𝐃𝐮𝐞 𝐃𝐢𝐥𝐢𝐠𝐞𝐧𝐜𝐞: 𝐖𝐡𝐲 𝐐𝐮𝐚𝐥𝐢𝐭𝐲 𝐨𝐟 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 (𝐐𝐨𝐄) 𝐓𝐞𝐥𝐥𝐬 𝐭𝐡𝐞 𝐑𝐞𝐚𝐥 𝐒𝐭𝐨𝐫𝐲 𝐁𝐞𝐡𝐢𝐧𝐝 𝐭𝐡𝐞 𝐏𝐫𝐨𝐟𝐢𝐭𝐬 Imagine buying a car that looks flawless — sleek paint, powerful engine sound, shining dashboard. But once you lift the hood, you realize half the parts have been replaced just to make it run for the test drive. That’s what a 𝐐𝐮𝐚𝐥𝐢𝐭𝐲 𝐨𝐟 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 (𝐐𝐨𝐄) 𝐚𝐧𝐚𝐥𝐲𝐬𝐢𝐬 𝐝𝐨𝐞𝐬 𝐢𝐧 𝐌&𝐀 𝐚𝐧𝐝 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐃𝐮𝐞 𝐃𝐢𝐥𝐢𝐠𝐞𝐧𝐜𝐞 (𝐅𝐃𝐃) — It looks under the hood of reported profits to reveal whether those earnings are real, recurring, and sustainable, or just polished for presentation. ⸻ 𝐖𝐡𝐚𝐭 𝐢𝐬 𝐐𝐨𝐄? A QoE report goes deeper than audited financials. It uncovers what portion of profits comes from core operations, and what stems from one-time, accounting, or management-driven adjustments. In short — 𝐐𝐨𝐄 𝐡𝐞𝐥𝐩𝐬 𝐝𝐞𝐚𝐥𝐦𝐚𝐤𝐞𝐫𝐬 𝐬𝐞𝐞 𝐭𝐡𝐞 𝐭𝐫𝐮𝐞 𝐞𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐨𝐰𝐞𝐫 𝐨𝐟 𝐚 𝐛𝐮𝐬𝐢𝐧𝐞𝐬𝐬 — 𝐧𝐨𝐭 𝐣𝐮𝐬𝐭 𝐭𝐡𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐩𝐫𝐢𝐧𝐭𝐞𝐝 𝐨𝐧 𝐭𝐡𝐞 𝐏&𝐋. ⸻ 𝐂𝐨𝐦𝐦𝐨𝐧 𝐀𝐝𝐣𝐮𝐬𝐭𝐦𝐞𝐧𝐭𝐬 𝐢𝐧 𝐚 𝐐𝐨𝐄- Non-recurring income or expenses (asset sales, settlements, write-offs) Revenue recognition or timing issues Related-party or management transactions Accounting policy changes Seasonality or timing distortions These adjustments bridge the gap between reported earnings and sustainable earnings, ensuring valuation rests on solid ground. ⸻ 𝐖𝐡𝐲 𝐐𝐨𝐄 𝐌𝐚𝐭𝐭𝐞𝐫𝐬 👉For Buyers: Reveals red flags and prevents overvaluation. 👉For Sellers: Builds credibility and strengthens negotiation power. 👉For Investors: Ensures valuation multiples apply to reliable, recurring profits. ⸻ 𝐀𝐭 𝐢𝐭𝐬 𝐜𝐨𝐫𝐞 — Quality of Earnings transforms financial statements from what’s reported to what’s reliable. Because in M&A, just like in buying a car — what’s under the hood matters more than the shine. 💭 𝐇𝐞𝐫𝐞’𝐬 𝐚 𝐭𝐡𝐨𝐮𝐠𝐡𝐭: If two companies report the same EBITDA, but one has cleaner, more sustainable earnings — Which one truly deserves the higher valuation multiple? 𝐈𝐟 𝐲𝐨𝐮 𝐟𝐨𝐮𝐧𝐝 𝐭𝐡𝐢𝐬 𝐡𝐞𝐥𝐩𝐟𝐮𝐥, 𝐟𝐨𝐥𝐥𝐨𝐰 𝐇𝐚𝐫𝐬𝐡𝐢𝐭 𝐟𝐨𝐫 𝐦𝐨𝐫𝐞 𝐢𝐧𝐬𝐢𝐠𝐡𝐭𝐬 𝐨𝐧 𝐌&𝐀, 𝐕𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 & 𝐃𝐞𝐚𝐥 𝐀𝐧𝐚𝐥𝐲𝐭𝐢𝐜𝐬. 𝐀𝐥𝐬𝐨, 𝐝𝐨 𝐥𝐢𝐤𝐞, 𝐜𝐨𝐦𝐦𝐞𝐧𝐭, 𝐚𝐧𝐝 𝐫𝐞𝐩𝐨𝐬𝐭 𝐬𝐨 𝐢𝐭 𝐫𝐞𝐚𝐜𝐡𝐞𝐬 𝐦𝐨𝐫𝐞 𝐟𝐢𝐧𝐚𝐧𝐜𝐞 𝐞𝐧𝐭𝐡𝐮𝐬𝐢𝐚𝐬𝐭𝐬. 🚀 #FinancialDueDiligence #M&A #linkedin #Investmentbanking #Equity

Understanding the Quality of Earnings The quality of earnings is a crucial concept in financial analysis, reflecting the reliability and sustainability of a company's earnings. It goes beyond just looking at the numbers on the income statement to assess how those earnings are generated and whether they are likely to continue in the future. 1. 𝗪𝗵𝗮𝘁 𝗶𝘀 𝗤𝘂𝗮𝗹𝗶𝘁𝘆 𝗼𝗳 𝗘𝗮𝗿𝗻𝗶𝗻𝗴𝘀? Quality of earnings refers to the degree to which a company's earnings are derived from its core business operations, rather than from one-time events or accounting adjustments. High-quality earnings are consistent, repeatable, and provide a true reflection of a company's financial health. 2. 𝗪𝗵𝘆 𝗶𝘀 𝗶𝘁 𝗜𝗺𝗽𝗼𝗿𝘁𝗮𝗻𝘁? Investors and analysts focus on the quality of earnings to determine the true value of a company. High-quality earnings suggest that a company is likely to sustain its profitability, making it a more attractive investment. Conversely, low-quality earnings might indicate that a company's reported profits are inflated or unsustainable. 3. 𝗙𝗮𝗰𝘁𝗼𝗿𝘀 𝗔𝗳𝗳𝗲𝗰𝘁𝗶𝗻𝗴 𝗤𝘂𝗮𝗹𝗶𝘁𝘆 𝗼𝗳 𝗘𝗮𝗿𝗻𝗶𝗻𝗴𝘀 𝗥𝗲𝘃𝗲𝗻𝘂𝗲 𝗥𝗲𝗰𝗼𝗴𝗻𝗶𝘁𝗶𝗼𝗻: Companies should recognize revenue in a manner that reflects actual sales activity. Aggressive revenue recognition can inflate earnings temporarily. 𝗘𝘅𝗽𝗲𝗻𝘀𝗲 𝗠𝗮𝗻𝗮𝗴𝗲𝗺𝗲𝗻𝘁: Properly matching expenses with revenues ensures that earnings reflect true profitability. Delaying expenses or capitalizing costs can artificially boost earnings. 𝗡𝗼𝗻-𝗥𝗲𝗰𝘂𝗿𝗿𝗶𝗻𝗴 𝗜𝘁𝗲𝗺𝘀: Earnings should primarily come from ongoing operations. Gains from asset sales or legal settlements can distort the true earnings picture. 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝗖𝗼𝗿𝗿𝗲𝗹𝗮𝘁𝗶𝗼𝗻: High-quality earnings are supported by strong cash flows. If earnings are rising but cash flow is not, it may indicate issues with earnings quality. 4. 𝗛𝗼𝘄 𝘁𝗼 𝗔𝘀𝘀𝗲𝘀𝘀 𝗤𝘂𝗮𝗹𝗶𝘁𝘆 𝗼𝗳 𝗘𝗮𝗿𝗻𝗶𝗻𝗴𝘀 𝗔𝗻𝗮𝗹𝘆𝘇𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄: Compare net income to cash flow from operations. Consistent cash flow supports earnings quality. Review Financial Notes: Look for any unusual items or accounting changes that might affect earnings. 𝗘𝘅𝗮𝗺𝗶𝗻𝗲 𝗥𝗲𝘃𝗲𝗻𝘂𝗲 𝗦𝗼𝘂𝗿𝗰𝗲𝘀: Ensure that revenue growth is coming from core business activities rather than one-time events. By focusing on the quality of earnings, investors can make more informed decisions, identifying companies with sustainable and reliable profit streams. *** P.S. Want to grow as an investor? Learn how to start analyzing companies based on their fundamentals. Unravel the mystery of Nvidia, Meta, and Google. Get my FREE Fundamental Analysis Visualized ebook here: https://lnkd.in/en6PA3aU

Due diligence terminology - Day 101 - Quality of earnings (QoE) adjustments- Overview   As a financial due diligence (FDD) practitioner – of all the analysis in a FDD report, Quality of Earnings (QoE) is perhaps the most closely watched, as enterprise value is often driven by FDD-adjusted EBITDA rather than the figures reported by the target management.   QoE is primarily concerned with appraising the sustainability, precision, and openness of a company's declared profits. In order for an earnings measure to be considered of high quality, it must reflect free cash flow and it must be sustainable.   Why is it QOE analysis important? - A successful $100k reduction/ uplift to EBITDA would translate to a $1 million adjustment to the enterprise value for a deal going at a 10x EBITDA multiple. Therefore, there is heavy scrutiny on the quality of earnings due to their potential impact on price.   The key challenge, however, lies in the ability to identify and quantify these QoE adjustments as a financial due diligence do not encompass audit procedures. The professional scepticism and experience of a seasoned due diligence professional will play a crucial role in detecting these adjustments.   QoE adjustments can be categorised into three buckets:- 1.    One-off / non recurring and normalising items - Items occurring in one period due to a specific, inhabitual event. E.g. One time transaction costs, restructuring initiatives, closure costs etc. 2.    Correction of an error/timing issue – wrong accounting entries, improper cut off issues and inappropriate GAAP or accounting policies. 3.    Proforma items - Harmonisation of the historical and forecast periods. Eg. Change in contract terms, standalone costs, synergies from proposed transaction etc.   Ultimately, a thorough review of earnings quality as part of financial due diligence is paramount. It ensures the accuracy, sustainability, and transparency of reported earnings, enabling stakeholders to make well-informed decisions. 

Last October, a seasoned investor lost $1.1 million in a single afternoon. Why? Because he skipped proper financial due diligence to "seize the opportunity”. Then he came to us. Here’s how we helped: 1️⃣ Quality of Earnings Analysis We looked past profits. Isolated recurring revenue from one-time gains. Uncovered accounting adjustments hiding real performance. 2️⃣ Balance Sheet Verification We verified assets. Identified off-balance sheet liabilities. Validated working capital to support the deal value. 3️⃣ Cash Flow Assessment We traced historical cash flow. Tested capex needs and future projections. Stress-tested numbers against market realities. 4️⃣ Tax Structure Review We flagged hidden tax risks. Checked compliance gaps. Found restructuring opportunities to optimize post-deal outcomes. 5️⃣ Financial Control Evaluation We assessed internal controls. Reviewed reporting systems. Spotted governance risks that could derail integration. The results?  ✅ ROI increased by 34% ✅ Deal risk reduced by 78% ✅ 92% of surprises eliminated post-acquisition. The investor later admitted: "I thought speed was my edge. Now I know—it’s only smart if you're rushing in the right direction." Strong due diligence tells the story behind the numbers. Don't let hidden risks sink your next deal. I help investors uncover the truth, fast and thoroughly. DM "Diligence" to protect your next transaction. #financialduediligence #finance #accounting 

Why a Quality of Earnings (QoE) Report is Critical for Business Buyers If you’re buying a small to medium-sized business, one of the smartest investments you can make during due diligence is a Quality of Earnings (QoE) report. Unlike standard financial statements, a QoE report goes beyond the surface to uncover the true, normalized earnings of the business. It adjusts for one-time events, owner add-backs, and unusual accounting practices that can distort the company’s actual performance. Most importantly, it helps you spot risks and trends that may not be obvious from the income statement or tax returns alone. I’ve seen buyers move forward with deals only to be blindsided later by things like: ✔️Customer concentration that wasn’t disclosed ✔️Declining margins masked by add-backs ✔️Seasonal revenue spikes treated as recurring ✔️Aggressive accounting decisions that inflate EBITDA ✔️Phantom profits due to underaccrued expenses A solid QoE report brings these issues to light—before you’re financially committed. For business buyers looking for someone who truly understands the unique dynamics of SMB acquisitions, one of my top recommendations is Chris Barrett, CPA with Midwest CPA . Chris is one of the hardest-working service providers I know in the ETA space. He’s fast, thorough, and committed to getting the details right. His reports are not only bank-ready but buyer-friendly, giving you the clarity and confidence you need to close (or walk away). Don’t skip this step. A quality QoE isn’t just about validating earnings—it’s about protecting your downside and negotiating from a position of strength. https://midwest.cpa/

Quality of Earnings can be painful - very, very painful - but it is a necessary part of selling your business. What do you need to know? Buyers commission a Quality of Earnings (QoE or "Q of E") report through a third-party firm to verify the financial health and sustainability of the earnings presented to them by the seller. The buyer wants to ensure they're making a sound investment and that financial characteristics of the business (e.g., earnings, revenue recognition practices, add-backs), are accurately represented. So - how should you prepare as an owner? 1️⃣ Prep Your Data - Ensure your financial records are thorough, organized, and up to date. It will make the process smoother and help you present your business accurately. Often times, the most painful part of QoE is getting the data together. 2️⃣ Get Ready to Explain...a Lot - Be prepared to explain and justify every decision you've made. QoE firms are trained to find reasons not to transact - don't take offense at their questions, just be prepared to answer them. 3️⃣ Transparency Wins - Honesty and transparency are your best allies in a QoE process. Have damaged inventory on the books as sellable? EBITDA addbacks that aren't really there? Be upfront about all aspects of your financials especially any potential red flags. It's the right thing to do & it builds trust and can help mitigate concerns from the buyer's side. 4️⃣ Have an Open Mind - It's easy to get frustrated when a bunch of accountants (that haven't spent the past decade in the trenches building a business) start questioning your decisions. However, try to remain level-headed and look at their feedback and questions as opportunities. Once you're out of QoE, you can use the results to inform changes you can make in the business. 5️⃣ Get Help - If you are comfortable, bring a trusted member of your team in the loop so they can help compile data and pull information. Further, lean on your M&A advisors to help you take as much off your plate as possible. Having a team to support you through QoE is critical to not get burned out from the combined work load of running a business and selling a business at the same time. #mergersandacquisitions #smallbusinessowner #manda

𝐘𝐨𝐮𝐫 𝐏&𝐋 𝐜𝐚𝐧 𝐥𝐢𝐞. 𝐂𝐚𝐬𝐡 𝐜𝐚𝐧’𝐭. 𝟖 𝐫𝐞𝐝 𝐟𝐥𝐚𝐠𝐬 𝐲𝐨𝐮𝐫 “𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬” 𝐚𝐫𝐞𝐧’𝐭 𝐫𝐞𝐚𝐥 ↓ Here are 8 red flags in earnings with real cases: 1️⃣ 𝐏𝐫𝐨𝐟𝐢𝐭𝐬 𝐠𝐫𝐨𝐰 𝐟𝐚𝐬𝐭𝐞𝐫 𝐭𝐡𝐚𝐧 𝐬𝐚𝐥𝐞𝐬: Enron showed rising profits even as sales slowed, until the fraud collapsed. 2️⃣ “𝐎𝐧𝐞-𝐭𝐢𝐦𝐞” 𝐜𝐡𝐚𝐫𝐠𝐞𝐬 𝐞𝐯𝐞𝐫𝐲 𝐲𝐞𝐚𝐫: GE regularly booked restructuring costs, turning recurring expenses into “one-offs.” 3️⃣ 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬 𝐬𝐰𝐢𝐧𝐠 𝐰𝐢𝐥𝐝𝐥𝐲: WeWork’s SG&A % bounced sharply, hiding costs of failed expansions. 4️⃣ 𝐀𝐥𝐰𝐚𝐲𝐬 𝐛𝐞𝐚𝐭𝐬 𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐬 𝐛𝐲 𝟏 𝐜𝐞𝐧𝐭: Sunbeam in the 1990s managed earnings to hit Wall Street forecasts quarter after quarter. 5️⃣ 𝐑𝐞𝐯𝐞𝐧𝐮𝐞𝐬 𝐟𝐫𝐨𝐦 𝐫𝐞𝐥𝐚𝐭𝐞𝐝 𝐩𝐚𝐫𝐭𝐢𝐞𝐬: Luckin Coffee inflated sales via fake transactions with affiliates. 6️⃣ 𝐅𝐫𝐞𝐪𝐮𝐞𝐧𝐭 𝐚𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐜𝐡𝐚𝐧𝐠𝐞𝐬: Toshiba shifted depreciation policies to flatter earnings before its 2015 scandal. 7️⃣ 𝐀𝐜𝐪𝐮𝐢𝐬𝐢𝐭𝐢𝐨𝐧𝐬 = 𝐢𝐧𝐬𝐭𝐚𝐧𝐭 𝐩𝐫𝐨𝐟𝐢𝐭𝐬: HP’s Autonomy deal looked like an instant boost, but later led to an $8.8B write-down. 8️⃣ 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐛𝐚𝐥𝐥𝐨𝐨𝐧𝐬: Carillion (UK) grew revenues on easy credit terms, but cash never caught up. Alone, these signs may be innocent. Together, they warn: dig deeper, trust cash flows over reported profits. 👉 Save this for your next interview prep or the next time you build a model, because sharp analysts are the ones who see past the headline numbers. Several? Save + share with your team. Follow Mohammed Abdul Gaffar, CFA #Finance #Accounting #CFA #FinancialModeling #EarningsQuality

Don't Overlook Critical Business Buying Factors In the realm of small business acquisitions, the buzz around wealth creation is undeniable. A crucial metric separates the savvy from the rest: Quality of Earnings (QoE). Beneath the gleaming financial reports can lie potential red flags: 1. Deceptive Revenue Practices: - Recognizing revenue prematurely - Falsely inflating sales through customer deposits - Presenting temporary surges as sustained progress 2. Dubious Performance Indicators: - Attributing Covid-related boosts as permanent growth - Disguising one-time occurrences as regular income - Engaging in inventory manipulation and last-minute sales pushes 3. Veiled Financial Realities: - Downplaying owner compensation - Questionable internal dealings - Camouflaging personal expenses within business outlays Remember: Sellers naturally showcase the best scenario. It's not about deceit but grasping the unembellished financial reality. Crucial Tip: QoE analysis isn't just another checkbox - it's your shield against major valuation mistakes. Consider this: You wouldn't purchase a home without an inspection. So why overlook due diligence in a seven-figure plus business deal? #BusinessAcquisition #Entrepreneurship #DueDiligence #WealthBuilding #SMB #QoE

💰 Not all profit is the same. Quality of Earnings matter for a buyer of a small business. If selling a business, here are a few things that could affect how a buyer sees your bottom line profit, and ultimately, the value of your business. 🔹 Past earnings trends. Are the years presented just a fluke overall? 🔹 Employment base. What's the tenure of employees, their skill-base? 🔹 Industry trends. 🔹 Customer concentration. Is majority of revenue from one customer? 🔹 Ease of transfer of contracts, customers, vendors, etc. There are firms I can recommend that prepare Quality of Earnings (QofE) reports for buyers/sellers when required by a lender or if they want to dig deeper into the numbers to see where potential blind spots are.