Quality of earnings, referred to as QoE, is an important financial analysis concept used to evaluate the soundness of reported earnings. Earnings reports are used to provide insight into a company’s financial health, but the reported numbers can easily be manipulated or skewed. Quality of earnings relates to the investor’s ability to trust the company’s stated numbers.

QoE is determined by analyzing a company’s income statement and balance sheet to identify anomalies, discrepancies, and one-time events. The goal is to reveal activities that are not indicative of a company’s true performance. This process helps investors gain a better understanding of the underlying health of a business, beyond the reported numbers. It increases transparency and helps to ensure that the company is following sound accounting principles.

When evaluating a company’s QoE, investors look at the company’s activity from the income statement through to the balance sheet and cash flow statement. It is important to look for any unexplained changes in a company’s cost structure, inventory levels, or amount of debt funding. Additionally, investors look for red flags such as net income that has increased without accompanying increases in cash flow from operations.

Generally, investors are looking for income that is generated from higher sales or lower costs. In other words, the quality of earnings is the percentage of income that is due to improved performance rather than one-time events or accounting tricks. If a substantial portion of the company’s income does not fall into these two categories, then this can be a sign of potential trouble.

To summarize, QoE is a measure of the amount of income generated by improved performance rather than accounting tricks. Investors use various methods to evaluate the quality of a company’s earnings, to determine if they can trust its reported numbers. This process helps protect investors from underhanded accounting tactics and hidden debt, while providing transparency into the true performance of a business.