Hi, I’m Chris Walton, author of this guide and CEO of Eton Venture Services.
I’ve spent much of my career working as a corporate transactional lawyer at Gunderson Dettmer, becoming an expert in tax law & venture financing. Since starting Eton, I’ve completed thousands of business valuations for companies of all sizes.
Read my full bio here.
Before investing in any business, it’s crucial to thoroughly understand its financial state.
You wouldn’t want to invest in a company that is consistently underperforming financially without a viable plan for future profitability.
Net income statements alone are not sufficient as they provide only a fraction of the financial narrative.
A business might be recording high revenues and positive net income, yet still be financially unstable due to significant outlays such as debt repayments and capital investments.
The solution lies in calculating the company’s Quality of Earnings (QoE) ratio.
This metric offers deeper insights into the financial status of the business and prompts further investigation if the ratio is low. The QoE ratio sheds more light on the authenticity of the company’s net income.
In this article, we’ll explain what QoE ratios are, why they’re important, and how to calculate them.
Key Takeaways:
Essentially, the Quality of Earnings (QoE) ratio is calculated to obtain a transparent view of a company’s earnings from its fundamental operations.
It filters out irregularities and accounting adjustments to provide a more accurate assessment of the company’s financial performance.
Without this ratio or its associated report, a company might manipulate its financial records to appear more profitable.
The ratio achieves this by excluding one-time or extraordinary items, thus assessing if the company’s earnings are consistent and reliable.
For instance, a company might show high net income but have negative cash flows, indicating that the income boost may not be from core business activities.
Investors should investigate the source of this income, as it might be an attempt to make the business appear more successful than it actually is.
A low QoE ratio does not necessarily indicate malpractice within the company.
It might be the result of a one-off cash influx boosting net income, or a significant expenditure leading to negative cash flows. It’s the investor’s responsibility to analyze these factors before committing.
📖Read more: Navigate M&A Like a Pro: The Quality of Earnings Analysis Guide
The calculation of a Quality of Earnings ratio is relatively simple.
It involves dividing the company’s net cash from operating activities by its net income.
The net income figures can be found on the income statement, and the net cash from operating activities is listed on the cash flow statement.
Here’s the formula and an example calculation:
Consider Company A, which reports a net income of $2 million for the fiscal year. However, this figure includes a one-time gain of $500,000 from the sale of a subsidiary and a $300,000 tax benefit. The company’s operating cash flow is $1.2 million.
To calculate the QoE ratio, you exclude these non-recurring items and compare the earnings from fundamental operations with the reported net income.
The QoE ratio is the adjusted net income divided by the operating cash flow:
Generally, a ratio above 1.0 is indicative of high-quality earnings, whereas a ratio below 1.0 may suggest earnings of lower quality, possibly distorted by anomalies or creative accounting.
For example, if a company’s net income post-operating expenses, depreciation, and taxes are $500,000, and its net cash from operating activities is $400,000, the QoE ratio would be 1.25 – a strong indicator of financial health.
Conversely, if the net income is $1 million and net cash from operating activities is $1.25 million, resulting in a QoE ratio of 0.8, it suggests a need for further investigation into the company’s financials.
A favorable QoE ratio can be beneficial in negotiations with lenders, particularly for SBA loans. Demonstrating a positive QoE ratio can significantly support your loan application.
To secure an SBA loan, you must present a business plan, determine the required capital, establish your credit history, and provide financial forecasts. A robust Quality of Earnings ratio makes it easier to project optimistic financial futures.
While calculating the QoE ratio is a good starting point, a comprehensive QoE report offers a deeper dive into a company’s financial standing. This report includes a QoE analysis, a categorization of various revenue types, and a breakdown of fixed and variable costs, along with distinguishing one-time and recurring expenses. The report doesn’t just provide a numerical value; it elucidates the sources of income and expenditures.
The report also includes an analysis of cash flow projections, offering a clearer picture of the company’s future financial trajectory. Having this data in advance simplifies the decision-making process for investment.
Calculating a Quality of Earnings ratio is a relatively simple task, but obtaining a full QoE report provides a comprehensive view of the company’s financial landscape, supplying all the necessary data before a business purchase.
This reduces your risk as you gain a better understanding of where the company’s finances are sourced and allocated, allowing for more accurate financial forecasting. This information can also facilitate loan acquisition.
At Eton, we’ve been providing M&A advisory and valuation support for the past 15 years. We specifically help companies with revenues between $5M and $150M navigate M&A deals with confidence.
Our team of ex-Big-4 consultants and lawyers can prepare an accurate, reliable, and court defensible valuation report (including Quality of Earnings report) in 10 days or less.
Reach out to us here for a free consultation.
Have more questions about Quality of Earnings ratio? I answered them below:
A good quality of earnings (QoE) ratio indicates that a company’s earnings are consistent and derived from its core business operations.
Typically, a ratio closer to 1 suggests high-quality earnings, as it shows that reported net income aligns well with operating cash flow after excluding one-time items.
This alignment means the company’s financial performance is stable and reliable.
The measure of quality of earnings involves assessing how much of the company’s income is generated from its main business activities, excluding non-recurring or unusual items.
This measure ensures that the earnings reflect the true economic performance of the company, providing a clearer picture of its financial health.
Quality of earnings refers to the degree to which a company’s earnings are sustainable and derived from its core operations.
High-quality earnings are consistent and not significantly influenced by non-recurring items, accounting adjustments, or financial engineering. They provide a more accurate representation of the company’s ongoing profitability.
The earnings quality score evaluates the reliability and sustainability of a company’s earnings. It considers factors like accruals, cash flows, revenue recognition practices, and the presence of non-recurring items.
A high score indicates that the company’s earnings are more likely to be sustainable and accurately reflect its financial performance.
Schedule a free consultation meeting to discuss your valuation needs.
Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.
