Last editedOct 20212 min read
There are many metrics that can provide an insight into your company’s financial health. But it’s important to be wary of metrics that, while initially comforting, may be misleading. Healthy revenue, for instance, may not necessarily indicate healthy business finances if your high overhead costs lead to anaemic profit margins.
Instead, it’s advisable to consider the metrics that factor into the due diligence process when companies make private acquisitions. One of the chief among these is quality of earnings. Here we’ll look at why it’s such an important metric and how to improve yours.
What is your quality of earnings?
Quality of earnings refers to your income in direct proportion to your operational costs. This goes a long way towards ascertaining your profitability.
If a company is able to improve sales while also driving down operational costs, its quality of earnings can be considered high. However, if a company incurs operating costs that stymie cash flow and reduce margins, its quality of income is considered low, even if turnover is high.
Quality of earnings can be undermined by:
Sale of assets for short-term gain
New government regulations
The use of accounting trickery to artificially bolster earnings
Earnings manipulation (where a company buys shares of its own stock)
Quality of earnings vs net income
There’s some similarity between quality of earnings and net income, and both are factors when determining the financial health of a company. However, in the case of acquisitions, quality of earnings is by far the more important metric. If net earnings are high but quality of income is low, the company may still be considered high risk.
Increasing net income artificially through clever accounting is a red flag. Instead, businesses should focus on taking active steps to improve cash flow by increasing operational efficiency. Temporary spikes in net income are not indicative of a healthy business. Instead, acquiring companies look for high-quality earnings that are repeatable over sequential reporting periods.
How to improve quality of earnings
As we can see, quality of earnings is a very important indicator of your company’s health, especially to outside investors. And unlike net income, it can’t be massaged through clever accounting to look healthier than it is.
Companies have to play the long game when improving their quality of earnings. Here are some ways to sustainably improve yours.
This is just good practice anyway. The more you know about the funds moving through your business, the better. But diligent reporting is the key to demonstrating high-quality earnings. When companies provide detailed reports as to the source of their earnings, and demonstrate accurate accounting, high-quality earnings are easily evidenced.
Investment in infrastructure
No amount of accounting trickery can give your company a foundation for sustainable growth. Instead, you need to invest judiciously in your infrastructure to improve operational efficiency and increase sales. This may involve making capital investments (e.g. plant or software). However, it’s not just about throwing money at the wall. It’s also about auditing your processes and streamlining your operations to eliminate wasteful spending.
Improving customer retention
A healthy turnover is the raw material from which healthy profit margins are made. How do we increase turnover without digging a marketing money pit? By improving customer retention and taking active steps to win back lapsed customers. This is generally more successful and affordable than moving new prospects through your sales funnel.
We Can Help
If you’re interested in finding out more about improving your quality of earnings, then get in touch with our financial experts. Discover how GoCardless can help you with ad hoc payments or recurring payments.