What is quality of earnings?
Two businesses can report the same profit, but one may earn it from recurring customer sales backed by cash, while the other relies on one-off gains or aggressive accounting. High-quality earnings are recurring, cash-generating and based on conservative accounting.
Signs of high-quality earnings
- [Operating cash flow](/glossary/operating-cash-flow) consistently close to or above [net income](/glossary/net-income)
- Revenue from recurring customers and core operations
- Stable margins
- Conservative revenue recognition and provisions
Red flags
- Profits rising while cash flow falls
- Large one-off gains or frequent "non-recurring" items
- Receivables growing faster than revenue
- Changes in accounting policies or estimates that boost profit
- Capitalising costs that would normally be expensed
Quality of earnings (QoE) report
In mergers and acquisitions, buyers often commission a QoE report from an accounting firm. It typically:
- Normalises earnings to [adjusted EBITDA](/glossary/adjusted-ebitda)
- Reviews revenue and customer concentration
- Analyses [working capital](/glossary/working-capital) needs
- Identifies debt-like items
- Tests the reliability of financial records