Unlocking the True Financial Picture: The Importance of Quality of Earnings Reports in M&A Transactions

ARTICLE | July 18, 2023

Whether you are considering buying or selling a business, having a comprehensive understanding of the company’s financials is paramount. While audits, reviews, and compilations ensure that the financial statements are accurate, a Quality of Earnings (QoE) assessment takes it a step further by providing an in-depth analysis of the revenue and expenses of the business. QoE reports are utilized by both buyers and sellers to evaluate and negotiate potential transactions. This article aims to shed light on the importance of QoE reports, their components, and the benefits they offer to all parties involved in M&A transactions.

What is a Quality of Earnings report?

A Quality of Earnings assessment focuses on the business’s earnings before interest, taxes, depreciation, and amortization (EBITDA), which is often used to calculate a company’s enterprise value. Financials are normalized and analyzed in the QoE assessment process to provide a granular view of core earnings.

When evaluating a transaction, a buyer needs to understand the revenue, expenses, and EBITDA on a go-forward basis. With a QoE assessment, adjustments are made to EBITDA to remove non-recurring transactions. For example, receiving PPP loan forgiveness, realizing a gain from the one-time sale of an asset, or receiving an insurance award are all one-time events that would not be expected to occur in the future and, therefore, would be adjusted.

A QoE assessment will also analyze balance sheet items such as customer prepayments, revenue recognition, uncollectable accounts receivable, and obsolete inventory to determine if adjustments to EBITDA are required.

The resulting dataset, after adjustments, provides a normalized view of core revenue, expenses, and EBITDA that can span multiple periods.

Additionally, a QoE report will include an analysis of the strength of the business and identify potential risks. The report will assess items such as customer concentration, vendor concentration, profit margins, variances, and trends. For example, a high concentration of revenue from one or a few customers may be putting the company at risk. A QoE report will contain both the analysis and corresponding commentary.

What are the benefits of a Quality of Earnings report?

Both buyers and sellers benefit from a QoE assessment because it provides much greater detail into a company’s financials.

Provides a normalized view of EBITDA. Adjustments to EBITDA are clearly identified, allowing buyers and sellers to work from core revenue, expenses, and EBITDA. This enables a buyer to better project post-transaction income and determine an appropriate transaction price.

Provides a buyer with critical information. A QoE report provides much greater detail about a company’s core operations than what is provided by audited financials. The buyer can better project earnings on a go-forward basis and uncover risks in the quality of the earnings. The insights provided by a QoE may reinforce a buyer’s current position or may cause the buyer to reconsider their offer. Regardless, the QoE provides more granular data enabling the buyer to make a well-informed decision.

Enables a seller to better prepare. A sell-side QoE enables the seller to view the business as a buyer. This helps a seller prepare for questions from and negotiations with a potential buyer. By preparing a QoE in advance, sellers can show that they are serious about the sale and willing to provide buyers with the information they need for their diligence.

Facilitates the transaction process. A QoE report gives both parties confidence in the accuracy of the financial data and provides the complete data in a well-organized format. Both parties can quickly access the data for analysis and negotiation.

A Quality of Earnings report is valuable to buyers and sellers in any potential M&A transaction. This article is intended to provide a brief overview of Quality of Earnings reports and is not a substitute for speaking with one of our expert advisors.

Please contact our Transaction Advisory Group to discuss how you or your business may benefit from a Quality of Earnings report.