Quality of Earnings Reports – What They Are and Why They Matter

Posted on January 13th, 2025 in Business Valuations

What is a Quality of Earnings Report?

A Quality of Earnings (QoE) report is a type of financial due diligence report often prepared as part of a mergers and acquisitions (M&A) transaction.  The depth, period covered, and nature of the analysis included in a Quality of Earnings report can vary depending on the complexity and nature of subject company and its financial reporting, and the perceived areas of risk by the user.

Due to differences in financial reporting practices that vary from company to company, and different accounting standards, the reported net income in a company’s financial statements may not necessarily be a reliable representation of the company’s ability to generate ongoing cash flows. Quality of Earnings does not have a standardized or regulated definition, but generally considers the amount of cash or non-cash earnings, recurring or non-recurring items, the precision of amounts recorded, or those involving estimates that are subject to judgment or change.

A QoE report analyzes the consistency of accounting policies, the degree of subjectivity or estimation, trends in reserves (i.e., warranty, bad debts, inventory, etc.), financial disclosures, and the impact of related party transactions in relation to reported accounting earnings/net income to provide a better understanding of the potential future ongoing cash flows that the business can generate.  Since cash flow is often a key consideration, working capital balances and trends are often analyzed to identify operational requirements and the time required to convert sales to cash.

In a QoE report, the reported earnings are typically normalized to account for items such as non-recurring transactions, non-market transactions, discontinued operations, changes in subjective estimates, and other irregular or non-continuing items. The result is the normalized earnings, which is often measured in earnings before interest, taxes, depreciation, and amortization (EBITDA).

Additional analysis of the company’s financial processes may also be conducted to provide a better understanding of how a company accrues or recognizes revenue and expenses, and the related cash inflows and outflows associated with these transactions.

Sources of information used in a QoE analysis may include financial statements, trial balance reports, general ledgers, company bank statements, and other detailed company financial information.

Why are Quality of Earnings Reports Needed?

A QoE report can be prepared for both the purchaser and the vendor in mergers and acquisitions transactions.

It is common for a purchaser to have a QoE report prepared during the due diligence phase of the transaction to assess potential risks of the transaction and for negotiating purposes. The lender that is financing the transaction or an insurer that is providing representations and warranties coverage may also require the purchaser to have a QoE report prepared to assist with financing or insuring the transaction.

A vendor may also want to have a  QoE report prepared in advance of a transaction to gain a better understanding of areas of the business that can be improved before taking the company to market or to alert them of any potential issues that could negatively impact a sale.

Our Expertise in Quality of Earnings and M&A Transactions

At DJB, our team of specialists have the professional experience to assist prospective buyers and business owners throughout the transaction process. Our trusted professionals can assist in many aspects of mergers and acquisitions transactions, including assisting in the financial and tax due diligence process and preparing Quality of Earnings reports.