Quality of Earnings: The Most Important Term You Probably Don’t Know

For those of you that have been through a recent business sale process, quality of earnings (Q of E) is a phrase that may still produce night sweats. For the rest of you, be aware that it is fast becoming one of the most important concepts in managing and evaluating your business.

At first blush, Q of E may seem straightforward. The words “quality” and “earnings” are familiar and common — but, when combined, they create a nuanced concept that can impact everything from your ability to borrow at favorable terms to a transaction’s value during a sale process. 

Depending on the source, Q of E is defined as “the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies or tricks, such as inflation of inventories, changing depreciation or inventory methodology”¹ or “the proportion of income attributable to the core operating activities of a business.”² While technically correct, these definitions fail to convey the whole story — instead, here is a practical application that you can use within your business.

Q of E is Revenue Minus Expenses, Adjusted for One-Time Cost

It is important to recognize that Q of E starts with quality of revenue. It is always a bit surprising how many businesses do not have a good handle on their revenue quality metrics. There are many instances when we encounter poor revenue recognition methodologies, which generally have a direct 1:1 offset to income. For example, if you do not have a bad debt reserve, yet you experience occasional write-offs or issue credits to your customers, your revenue and earnings are overstated by the same amount. 

Furthermore, we rarely see well-developed revenue waterfall reports (delineation between booked, under-contract, verbal award, etc.). While not technically a component of a Q of E report, the better documented and predictable your revenue flow, the more likely it is that positive adjustments to your Q of E will stick. Consistency and predictability of revenue increase value, whereas volatility and unpredictability in revenue reduce value.

For any adjustment to revenue or expenses to truly qualify as something that improves Q of E, it must have credible sustainability. For example, many times we see “one-time” expenses adjusted out that occur every year; an investor is going to have a hard time believing that the expense reduction is going to be sustained going forward. Conversely, adding back excess compensation where the new compensation level is documented in an employment agreement is perfectly acceptable.

Another thing to consider is whether the expenses are associated with the revenue. In other words, how much did it cost to generate the revenue? 

Investors are very interested in ensuring that all of the costs are included, because they want to be comfortable that the company can continue to generate the same revenue without incurring more costs.

Last is the notion of perception, which really only applies to those situations in which your Q of E is being evaluated by third parties for some kind of transaction. If you are considering a sale of the business, you clearly want to show the highest possible level of earnings, as most valuations are based on the earnings stream. However, if the presented earnings include adjustments attributable to things like accounting method changes, recent expense reductions or price increases, cost savings from short-term commodity price fluctuations or similar factors, then even your completely supportable/sustainable adjustments will be called into question, and you may not receive full value consideration. The perception of adjustments is important; for example, if a significant adjustment is for recent cost savings, it could cause an investor to wonder why the management team has not been operating the business as efficiently as possible all along.

Take the time to understand your Q of E, and it will better prepare you for discussions with investors, lenders and/or buyers.

References

1. “Quality of Earnings.” Investopedia. 12 Jul. 2018. Web.
2. “Quality of earnings.” Accountingtools.com. 4 Feb. 2018. Web.