spotting-quality-of-earnings-issues-and-adjustments — fundamental analysis

The practical point: reported earnings are a negotiated number, and the negotiation happens between GAAP constraints and management incentives. Your job is to reverse-engineer what was added back, why, and whether the adjustments reflect economic reality or presentation preference.

Why Quality of Earnings Analysis Matters

Public companies report two versions of earnings: GAAP net income (audited, rule-bound) and non-GAAP "adjusted" earnings (management's preferred view). The gap between them has widened. In one study covering S&P 500 firms, the median difference between non-GAAP and GAAP EPS was $0.02 in 2003 but $0.42 by 2018 (Bentley et al., 2018). That's a 21x increase in the adjustment gap over 15 years.

Why this matters: if you use adjusted earnings without checking what's been excluded, you're letting management pick your inputs. The point is: quality of earnings analysis is the discipline of measuring how much of reported profit converts to cash and how much is accounting classification.

GAAP vs Non-GAAP Reconciliation (The Starting Point)

What the reconciliation tells you

Every company reporting non-GAAP metrics must provide a reconciliation table (SEC Regulation G). This table shows the path from GAAP net income to the adjusted number. You read it line by line.

A useful framework:

GAAP Net Income → + Add-backs → - Subtractions → Non-GAAP "Adjusted" Earnings

Common add-back categories:

Stock-based compensation (SBC): treated as "non-cash"
Restructuring charges: severance, facility closures
Acquisition/integration costs: legal, advisory, system integration
Amortization of intangibles: from prior acquisitions
Impairment charges: goodwill or asset write-downs
Litigation settlements: one-time legal costs

The point is: each add-back has a legitimacy spectrum, from clearly non-recurring to aggressively normalized.

Common Add-Backs (Legitimate vs Aggressive)

Stock-based compensation: the most contested add-back

SBC is the most common non-GAAP adjustment. Management argues it's "non-cash." The problem: SBC dilutes your ownership and represents real compensation that would otherwise require cash.

Legitimate treatment: Add back for cash flow purposes (SBC doesn't consume cash this period).

Aggressive treatment: Add back for valuation purposes (pretending employees work for free).

A practical threshold: if SBC exceeds 10% of operating income consistently, you should treat it as a core expense. In tech, SBC often runs 15-25% of operating income. Adjusting it out inflates margins by hundreds of basis points.

Why this matters: SBC is a real cost paid by shareholders through dilution. Adding it back flatters earnings without eliminating the economic transfer.

Restructuring charges: frequency determines legitimacy

Restructuring is theoretically one-time. In practice, many companies restructure continuously.

Legitimate: A single reorganization following a strategic pivot, with charges confined to 12-18 months.

Aggressive: Annual restructuring charges that appear in 5+ consecutive years (making them a recurring operating cost).

A detection rule: compute the 5-year average of restructuring charges. If the average exceeds 5% of operating income, treat it as a core expense regardless of labeling.

Acquisition costs: watch for serial acquirers

Integration costs from M&A are often added back. For occasional acquirers, this makes sense. For serial acquirers, acquisition is the business model.

The test: if a company makes 2+ acquisitions per year and adds back integration costs annually, those costs are operating expenses by definition.

The point is: the legitimacy of an add-back depends on frequency, not just category.

Accruals Analysis and the Sloan Ratio

Why accruals matter for earnings quality

Accruals are the non-cash portion of earnings. High accruals signal that earnings are supported by accounting entries (estimates, deferrals) rather than cash. The classic finding: firms with high accruals underperform low-accrual firms by 10.4% annually in the subsequent year (Sloan, 1996).

How to calculate the Sloan ratio

The Sloan accrual ratio measures the accrual component of earnings:

Total Accruals = Net Income - Operating Cash Flow

Sloan Ratio = Total Accruals / Average Total Assets

Interpretation thresholds:

Sloan Ratio < -5%: Low accruals, cash-rich earnings (high quality)
Sloan Ratio -5% to +5%: Normal range
Sloan Ratio > +5%: High accruals, earnings exceed cash (lower quality)
Sloan Ratio > +10%: Elevated accrual risk (investigate specific drivers)

Why this matters: the Sloan ratio forces a single-number comparison between earnings and cash. It's a mechanical quality screen that works across industries.

CFO/Net Income Divergence (The Cash Conversion Test)

The core signal

Operating cash flow (CFO) should track net income over time. Persistent divergence signals quality issues.

CFO/NI Ratio = Operating Cash Flow / Net Income

Interpretation:

CFO/NI > 1.2x for 3+ years: High quality (earnings are cash-backed)
CFO/NI 0.8x-1.2x: Normal range
CFO/NI < 0.8x for 2+ years: Lower quality (accrual buildup)
CFO/NI < 0.5x: Investigate immediately (earnings not converting)

What drives divergence

When CFO lags net income, typical causes include:

Rising receivables: Revenue recognized but not collected
Inventory buildup: Production outpacing sales
Deferred expenses: Costs capitalized rather than expensed
Aggressive revenue recognition: Sales recorded before cash is probable

The point is: a company can report growing earnings while cash generation deteriorates. The CFO/NI ratio catches this before it becomes a write-off.

Worked Example: Adjusting Reported Earnings for TechCorp

You evaluate a software company (fictional "TechCorp") with the following reported metrics:

Reported figures (FY2024):

GAAP Net Income: $180M
Non-GAAP "Adjusted" Net Income: $320M
Operating Cash Flow: $210M
Total Assets (average): $2,400M
Revenue: $1,800M

Management's add-backs (from reconciliation table):

Stock-based compensation: $85M
Restructuring charges: $28M
Acquisition-related costs: $18M
Amortization of acquired intangibles: $9M
Total add-backs: $140M

Step 1: You test the CFO/NI ratio

CFO/NI = $210M / $180M = 1.17x

This falls in the 0.8x-1.2x normal range. Cash conversion is adequate but not exceptional. (You note it's below the 1.2x high-quality threshold.)

Step 2: You calculate the Sloan ratio

Total Accruals = Net Income - Operating Cash Flow Total Accruals = $180M - $210M = -$30M

Sloan Ratio = -$30M / $2,400M = -1.25%

This is in the normal range (between -5% and +5%). The negative sign is favorable (cash exceeds earnings). You score this as "acceptable quality."

Step 3: You evaluate each add-back

SBC ($85M):

SBC as % of GAAP Net Income: $85M / $180M = 47%
SBC as % of Revenue: $85M / $1,800M = 4.7%

This is material. SBC represents nearly half of GAAP earnings. You check the 5-year trend: SBC has been $60M, $68M, $75M, $80M, $85M (growing 8.9% CAGR). This is a core, recurring cost.

Your adjustment: Add back 0% of SBC for valuation purposes (treat as real compensation expense).

Restructuring ($28M): You check the 5-year history: $25M, $22M, $30M, $26M, $28M (every year). 5-year average: $26.2M/year

This is not a one-time cost. It's an annual operating expense.

Your adjustment: Add back 0% (treat as recurring).

Acquisition costs ($18M): TechCorp made 3 acquisitions in FY2024 and has averaged 2.5 per year over 5 years. M&A is the growth strategy.

Your adjustment: Add back 0% (serial acquirer pattern).

Intangible amortization ($9M): This relates to past acquisitions. Unlike SBC, it doesn't require future cash or dilution. It's a legitimate add-back for cash-based analysis.

Your adjustment: Add back 100% ($9M).

Step 4: You compute your adjusted earnings

Your Adjusted Net Income = GAAP Net Income + Legitimate Add-backs Your Adjusted Net Income = $180M + $9M = $189M

Management's Adjusted Net Income: $320M Your Adjusted Net Income: $189M Difference: $131M or 41% lower

Step 5: You calculate valuation impact

If TechCorp trades at $6.4B market cap:

P/E on Management's Adjusted EPS: $6,400M / $320M = 20x
P/E on Your Adjusted EPS: $6,400M / $189M = 34x

The point is: using your adjustments, the stock is 70% more expensive than the headline multiple suggests.

Detection Signals (Red Flags to Watch)

You're likely facing aggressive earnings adjustments if:

Non-GAAP earnings exceed GAAP by >40% consistently
SBC exceeds 15% of operating income but is fully added back
"Non-recurring" charges appear in 4+ consecutive years
CFO/NI ratio is <0.8x for 2+ consecutive years
Sloan ratio exceeds +10% (accruals far exceed cash)
Management emphasizes adjusted metrics while GAAP deteriorates

The durable lesson: red flags cluster. One aggressive add-back is a judgment call; three is a pattern.

Implementation Checklist (Tiered by ROI)

Essential (do for every stock you own)

Locate the GAAP-to-non-GAAP reconciliation in quarterly earnings releases
Calculate CFO/NI ratio: require >0.8x for 2+ years, prefer >1.2x
Calculate Sloan ratio: flag if >+5% (investigate if >+10%)
Test SBC materiality: if >10% of operating income, do not add back for valuation

High-impact (do for concentrated positions)

5-year average "non-recurring" costs: treat as recurring if >5% of operating income
Track add-back growth rate: if add-backs grow faster than revenue, quality is declining
Compare management guidance basis: note whether guidance uses GAAP or adjusted metrics

Optional (for deep dives)

Decompose accrual drivers: receivables, inventory, payables trends
Benchmark add-backs to peers: outlier adjustments suggest aggressive presentation
Read auditor notes on estimates: unusual language signals judgment risk

The durable lesson

The durable lesson: quality of earnings analysis is arithmetic, not opinion. You calculate the CFO/NI ratio (target >1.2x), the Sloan ratio (flag >+5%), and the frequency of "non-recurring" items (5-year averages). Then you rebuild adjusted earnings using your standards, not management's. The gap between your number and theirs tells you how much presentation preference has been embedded in the stock price.

Spotting Quality of Earnings Issues and Adjustments