Traders need to know to read company reports if they trade equities. One of the important reports is the Quality of Earnings Report.
Quality of earnings report represents a detailed analysis of all the components of a company’s revenue and expenses and a true reflection of the income that a company can generate from its core operation without anomalies or accounting tricks. The company’s expenses and revenue are documented in the earnings report’s quality, which is usually prepared by third-party firms. This report can be requested by an investment committee or board of directors. This report is essential because it gives a company’s historical earnings that will determine the achievability and sustainability of future projections.
Net income doesn’t give substantial proof of the financial capabilities of a company. A company can have a huge net income but negative operating cash flow.
Some companies can manipulate their earnings using accounting conventions to make the company have an intuitive value, which will attract more investors. Others do so to lower tax liabilities. Therefore, this article will help you understand more about the quality of the earnings report. Let’s get started.
Quality of Earnings Report
The earnings report’s quality is based on both the internal and external financial capabilities of a company. For instance, if the company has a strategy to boost its sales through marketing, then it is appropriate to say that that particular company has a high quality of earnings. This is because it was an internal initiative that was evaluated and implemented, and eventually, it brought returns to the company.
However, if a company largely participates in external forces to build its credibility the increasing the price of commodities that the company is regarded to have low-quality earnings. Therefore, there is a high possibility for a company that has low-quality earnings to manipulate its earnings. Companies with high-quality earnings will stick to GAAP standards based on relevance and Reliability. Relevance has predictive power, which can be used to ascertain the previous predictions that had been made. On the other hand, reliability is a verifiable metric that helps in accurately representing the transaction.
How to Gauge Quality of Earnings
It is possible to gauge the quality of earnings by looking at the cash flow statement, balance sheet, and income statement.Net income are among the most aspects that financial analysis focuses on to tell the overall performance of a company. Quality of earnings gives the reliability of the figures obtained during the critical analysis. Cash flow details and balance sheet will enable a financial analyst to hypotension as to why the company has a high-income net but negative cash flows. There might be a variation between the net income and cash flows.
Therefore the quality of earnings analysis include:-
-Determining fixed and variable costs
-Analyzing assumptions used In cash flow projection analysis.
-Breaking down of revenue based on appropriate components such as products/services and customers.
-Analyzing historical revenue trends
-Determining recurring expenses and one time expenses
-Analyzing the impact on revenue and expenses due to management changes.
Other items that can gauge the quality include transparency of disclosures, disclosure of related party transactions, consistency in accounting policies, and reserve balances. Low-quality report earnings are largely influenced by inflation, an increase in the pricing of commodities, aggressive use of accounting rules, and profit from an asset’s sale.
How Quality Earnings Works
As we have seen, several options can be used to gauge the quality of earnings by analyzing the company’s financial report.
Most analysts will look at the highest income statement because a company can show high sales and credit sales growth. Like the variation between net income, other parameters will greatly help in coming up with a substantial report. However, non-recurring expenses or income is a red flag for the company. This is because a company may refinance all its debts leading to a decrease of that year’s expenses, but it might affect future payments.
It brings worries when a company resort to take another debt. That is why some companies resort to manipulating their earnings through price to earnings ratio and earnings per share. In this way, they will have to purchase Sha of its stocks, reducing the number of outstanding shares. When such a case happens, the company’s financial stability will gradually fade. When investors establish such a creepy move, they will no longer invest in such a company.
Therefore, relying only on financial statements without a clear understanding can be disastrous. That is why it is always advisable as an investor to have a side quality of earnings report, which provides a more detailed and representative picture of how the business is being conducted. This helps in evaluating whether it is worth investing in.
Quality of earnings report sample
Factors Affecting Quality Of Earnings
Quality of earnings is important to prospective investors. Quality of earning can be used to determine the congruence between the integrity of the company balance sheets and economic earnings. The financial statements that are normally given might not reflect the true picture. Therefore, these factors can be summarized as the degrees to which earnings are recurring or non -recurring, cash or non-cash, and basing on estimates and precise measurements subject to change.
Why You Need a Quality of Earnings Report
A financial statement is a useful tool for gauging the general health of a company. However, it does have its weaknesses. Since a financial statement tries to present information that encompasses a broad spectrum, it tends to miss the finer details.
And yet, specific minute details can significantly impact how you should see the overall picture. For example, a change in production, a deficient expenditure, or big single-time sales does not reflect the image’s entirety. It’s like injecting nitro into a car to accelerate it faster and labeling the rate as the car’s normal speed.
It can also work the other way around. And that means trying to downplay a specific metric for whatever reason. Most of these activities can deflate or inflate the statement, consequently altering the perceived value and performance.
So if you are an investor, buyer, or seller, how do you get a more accurate picture? That’s where the quality of earnings (QoE) report comes into play.
Quality of Earnings Report – What Is It
QoE is generally a crucial part whenever you are investing in a business. It’s also essential whenever you want to sell or buy a business. In fact, it should be a part of every due diligence.
QoE also comes in different sub-categories. For example, if you are selling a business, you’d want to check the sell-side QoE. If you are buying a business, then you should be looking at the buy-side QoE. Generally, the difference is based on who is requesting such a report.
One of the purposes of QoE is to identify earnings that can significantly impact the report. Yet, it’s not the normal or an unrepeatable cashflow or performance of a business over a period of time. The reason for such a “spike” could be a multitude of sources like business climate changes or accounting choices.
While QoE often focuses on the income part of the financial statement, it also combs through other details with finer teeth. For example, it examines the worth and condition of various assets reported on the balance sheet.
Finally, QoE also considers the systems of control of a company. And some aspects within the business operation like product line, industry, clients, and other related metrics.
Generally, QoE is fundamentally different when analyzing the balance statement compared to a review or audit.
Quality Of Earnings Report VS. Financial Statement – The Difference
One of the significant purposes of a financial statement is to give a certain level of assurance that a business conforms to the generally accepted accounting principles. You can say that a financial statement looks into the past.
On the other hand, QoE aims to understand the sustainability of the company’s income on a detailed level. In other words, it is a report that looks into the future health of the business.
Why Do You Need Quality Of Earnings Report?
There are plenty of reasons why you may need a QoE report. Perhaps, the most important reason is that a QoE is a report which analyzes detailed aspects of a business that may not be readily available when checking the financial statement only.
Keep in mind that the report, like the QoE, is not an evaluation. However, it still plays a critical part when structuring or negotiating a deal. It can help in significantly reducing risk. Avoiding the possibility of a buyer’s or seller’s remorse is another desirable outcome of a QoE report.
Sell-Side QoE Report
For a seller, the sell-side QoE can help uncover potential business problems that may derail the sale of the business. Or, it can also reduce the pressure of some buyers that like to press aggressive negotiation tactics. After all, a solid QoE report will deter buyers from using “uncovered” information with the hopes of reducing the price. The QoE can also shorten the selling process as more information is already on the table.
However, if you are selling a business, it’s also a good idea to comb through the buy-side QoE report. It will give you a better perspective from the buyer’s side of the fence, leading to a smoother selling process.
Buy-Side QoE Report
If you buy a business, you must comb through as much information as you can. Always remember that more information can reduce risk further. If your idea of due diligence is only checking out the financial statement, then that can potentially lead to disastrous results.
It’s highly advisable that if you are buying a business, the due diligence should include a buy-side QoE done by an independent third party. The report should drill down the operations, cash flow, and account balances.
The buy-side QoE report will also be an invaluable tool for investors. It can help paint a better picture of how well the business is doing. Ultimately, it can help you gauge if the company is worth the current price of its stock.
Keep in mind that the QoE report is typically done by a third-party that is not connected with the business that will be analyzed. This is to minimize any bias that may affect the final report. Generally, the QoE will typically include, but not limited to:
* Unusual variances and trends within the internally prepared income statements and balance sheet.
* Potential accounting practices or policies.
* Non-recurring or unusual items found in the expense or income tabs.
* Transactions with unusual parties
* In-depth report of proof of cash.
* Customer sales, backlog, and concentrations analysis.
* Analysis of key allowance and reserves.
A financial statement is a crucial component if you want to gauge the health of a business. Hence, every seller, buyer, or investor will check it before doing anything. However, the nature of financial statements merely gives you a broad stroke picture or ensures that the business is compliant with the generally accepted accounting practices. In other words, it tends to miss things that can significantly impact the overall picture. It’s the reason why that financial statement should be complemented with a QoE report.
A QoE report takes a closer look at the sustainability of the business. It helps uncover income, performance, or other vital aspects that are “unusual” or not part of what’s “normal.” At its core, it’s a report that looks into the future by ensuring that the current sales or performance of a business will likely continue and not be brought on by something unusual.
It is important to know that you can’t measure the quality of income with a single characteristic. Therefore, certain indicators should be used to assess the quality of income, which explains why there is a need for the audit committee and financial statement experts to be prudent when evaluating financial reports.