Quality of Earnings: What It Means & How to Analyse It

Discover Quality of Earnings to learn how reliably reported profits reflect a company’s true financial performance.

The Quality of Earnings (QoE) refers to how accurately a company’s reported profits reflect its true, sustainable economic performance. In other words, QoE assesses whether earnings are derived from core, recurring business operations rather than temporary, non-operational or accounting-driven adjustments. Investors, acquirers, lenders, and analysts rely on QoE analysis to evaluate the reliability of a company’s earnings and determine whether profits are sustainable.

High-quality earnings indicate that profits are supported by stable operations, reliable cash flows, and transparent accounting practices. A low quality of earnings, on the other hand, may signal red flags such as aggressive revenue recognition, excessive adjustments, or earnings inflated by one-time items.

Quality of Earnings (QoE) is a financial evaluation that measures how much of a company’s net income is derived from recurring, core business activities versus non-recurring or accounting-based adjustments. The goal is to determine how “real” and sustainable the earnings are. QoE is especially important in mergers and acquisitions (M&A), equity valuations, and credit assessments, as it helps stakeholders gauge the stability and predictability of future earnings.

Unlike traditional audits, QoE focuses on economic performance rather than compliance. Analysts look beyond the income statement to examine working capital, cash flows, and operational drivers to ensure earnings are not overstated or distorted.

QoE analysis is essential for multiple reasons:

• M&A Due Diligence: Buyers need to know whether the seller’s reported profits are sustainable before determining valuation.
  

• Investor Confidence: High-quality earnings improve transparency and help investors assess long-term value.
  

• Business Forecasting: QoE helps determine whether past earnings can reliably predict future performance.
  

• Detection of Accounting Manipulation: QoE highlights red flags in revenue recognition, expenses, and accruals.
  

• Creditworthiness Assessment: Lenders evaluate QoE to assess repayment capacity.

Because earnings can be influenced by one-time gains, extraordinary items, or aggressive accounting, QoE filters out distortions and reveals the company’s true profitability.

QoE analysis typically includes the following components:

• Revenue Quality – recurring vs one-time revenue streams.
  

• Expense Quality – normalisation of unusual, excessive, or discretionary expenses.
  

• Working Capital Review – assessing whether earnings keep pace with cash requirements.
  

• Cash Flow Analysis – converting earnings into cash to check liquidity.
  

• Customer/Supplier Concentration – evaluating stability and risk exposure.
  

• EBITDA Normalisation – adjusting for add-backs to get true operating earnings.

Normalising Adjustments

These adjustments remove items that distort true earnings, such as:

• One-time legal settlements
  

• Non-recurring gains or losses
  

• Excessive owner salaries
  

• Discontinued operations
  

• Unrealistic management add-backs

Normalisation ensures EBITDA and net income reflect ongoing performance.

Recurring vs Non-Recurring Earnings

Recurring earnings originate from core business operations and form the basis of valuation. Non-recurring items, such as asset sales or pandemic-related subsidies, inflate profits artificially. QoE separates these to assess sustainability.

Cash Flow & Working Capital Link

High reported earnings may not reflect true performance if cash flow is weak or working capital needs are increasing. QoE evaluates:

• Cash conversion
  

• Aging of receivables
  

• Inventory buildup
  

• Payables management

This reveals whether earnings are supported by real cash.

While QoE is largely qualitative, analysts often use ratios to assess earnings sustainability. The key formula is:

• Quality of Earnings Ratio = Cash Flow from Operations ÷ Net Income

A ratio above 1 indicates strong earnings quality. A ratio below 1 suggests earnings may not convert well into cash.

Earnings-to-Cash Flow Ratio

The formula is as follows:

Earnings-to-Cash Flow = Net Income ÷ Operating Cash Flow

• < 1 = High-quality earnings
  

• > 1 = Potential quality issues

A big divergence between profit and cash flow is a major red flag.

Other Diagnostic Ratios

• Accrual Ratio
  

• Cash Conversion Cycle
  

• EBITDA-to-Cash Flow Ratio
  

• Working Capital Turnover

These ratios help identify aggressive accounting, slow inventory movement, or weak collection cycles.

The following steps outline a typical QoE review process:

1. Scoping & Planning
   Define objectives (valuation, M&A, internal review), identify focus areas, and gather preliminary financials.

2. Data Collection
   Collect audited statements, management reports, general ledgers, tax filings, contracts, and bank statements.

3. Adjustments & Review
   Apply normalisation adjustments, analyse revenue channels, evaluate expense legitimacy, and test cash flows.

4. Reporting & Findings
   Summarise adjusted EBITDA, recurring earnings, cash flow insights, risks, and valuation implications.

A QoE assessment highlights how sustainable, recurring, and transparent a company’s earnings truly are.

A strong QoE report indicates:

• High recurring revenue

• Low dependence on one-time gains

• Solid cash flow conversion

• Transparent accounting practices

• Stable customer and supplier relationships

A weak QoE report may point to inflated earnings, concentration risks, weak cash flow, or aggressive accounting methods.

Companies may enhance QoE by:

• Strengthening internal controls
  

• Improving receivable collection
  

• Reducing reliance on one-time revenue
  

• Controlling discretionary expenses
  

• Enhancing transparency in accounting
  

• Streamlining working capital management

These processes differ in purpose and depth, even though they relate to financial accuracy.

• Audit: Focuses on compliance with accounting standards and verifies reported figures.

• QoE: Examines the sustainability and underlying economic reality of earnings.

• Financial Due Diligence: Covers a wider scope, including QoE, financial risks, and valuation impacts.

Automation, AI-based anomaly detection, and real-time data analytics are becoming common tools in QoE reviews. These technologies help identify revenue manipulation, unsustainable cash flows, and operational inconsistencies faster and more accurately.

Quality of Earnings analysis is essential for evaluating sustainable business performance. By filtering out noise, one-time items, and accounting distortions, QoE gives investors and acquirers a clear and accurate view of a company’s true profitability. High QoE reflects reliable earnings, which is often considered by stakeholders in valuations and business assessments.

Key points to remember:

• QoE focuses on sustainability and consistency of earnings.

• Strong QoE indicates stable earnings, which may inform valuation and stakeholder assessment.

• Weak QoE may signal risks in cash flow, customer dependence, or accounting practices.

• Technology is making QoE assessments faster and more detailed.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.