Quality of Earnings
A quality of earnings analysis tests how robust and repeatable reported earnings are. It examines the composition and sustainability of income, the proximity of earnings to cash flow, and recognition practice, and forms the core of any financial due diligence.
Not how much, but how reliable
A statutory audit answers whether a set of accounts complies with the accounting rules. A quality of earnings analysis answers a different question: whether reported earnings describe the business accurately and whether they can be repeated. Accounts can be formally impeccable and still show earnings that will not arise again next year.
What is examined
- Composition of income. Recurring or project-based, concentration on individual customers, development by cohort, dependence on individual contracts and their remaining term.
- Recognition practice. When revenue is recognised, how prepayments are treated, how deferred revenue develops. In subscription models this is the central point.
- Earnings against cash flow. Earnings that do not turn into cash over years are a warning sign. The bridge from EBITDA to operating cash flow belongs in every QoE.
- Working capital. Development over at least 24 months, seasonality, cut-off effects – a receivables balance that is unusually low exactly at the valuation date, for instance.
- Adjustments. The EBITDA normalisation presented by the seller is tested item by item and regularly cut back.
- Provisions and impairments. Whether they are adequately measured, or whether their release has supported earnings.
Findings that recur
The recurring patterns are: released provisions that appear as operational improvement; capitalised development cost that takes expense out of the income statement; revenue recognised too early; deferred maintenance that lifts margin in the short term; and working capital flattered at the balance sheet date by delayed payments to suppliers.
None of these is in itself an accusation. They become a problem when the buyer is the one who finds them.
Consequence for preparation
The QoE is the part of the review in which the price is most often corrected. Anyone intending to sell is therefore well advised to run it themselves before the process starts – as part of a vendor due diligence or internally. The prerequisite is unspectacular: monthly reporting reconciled to the statutory accounts, a complete bridge for the adjustments, and a working capital series that does not first come into existence during the process.