By Daniel S. Hughes, CPA/CFF/CGMA, CVA
Business sales, mergers and acquisitions involve a delicate dance between sellers, hoping to receive the maximum amount for their companies, and buyers, who want to ensure that the price they pay aligns with the reality of the business’s current operations and ongoing financial performance.
A critical component of a buyer’s due diligence process has been a quality of earnings (QOE) study that takes a deep dive into a target company’s financial performance and profitability in order to determine a stream of predictable future earnings potential. However, in today’s active deal environment, sellers in need of a competitive advantage are proactively hiring independent accounting firms experienced in M&A transactions to conduct QOE studies before they even put their companies up for sale. Doing so helps to accelerate the due diligence process while also providing sellers with an opportunity to identify and remedy issues that can delay or terminate a potential sale. In turn, sell-side QOEs can potentially lead to a higher selling price and reduced exposure to post-closing litigation.
What is a quality of earnings report?
A QOE is an objective analysis of a company’s historic financial records to establish a realistic baseline of its current financial performance and determine whether or not the baseline level of profitability is sustainable in the future.
Unlike an audit, which verifies and authenticates a company’s financial position and performance, a QOE restates the company’s performance by making adjustments for one-time events and extraordinary revenues or expenses. A QOE delves beyond the numbers reported in financial statements to understand the sustainable and forward-looking performance of a business at a very detailed level. It identifies operating trends, anomalies, problem areas and other factors that can affect the business’s selling price today and its earnings projections going forward under new ownership.
In this sense, a QOE can be compared to a consumer hiring a professional mechanic to look under the hood and inspect a used car before making a purchase. The mechanic can tell the buyer if there are issues or risks that impact the car’s current value, the price they pay for it and/or the number of years they can expect to use and derive enjoyment from the vehicle without significant investment in repair and maintenance services.
Buyers financing a purchase with debt will often be required by their lenders to get an independent QOE to demonstrate the target company’s track record of profitability and liquidity. Typically, lenders require at least three years of prior financial results to evaluate a business and determine loan eligibility and terms.
What does a quality of earnings report cover?
A QOE helps to understand a company’s performance data by industry, customer, product line, or other relevant business metrics.
While the methodology and approach to a QOE report varies based on buyers’ and/or sellers’ specific needs and goals, evaluation always focuses on the factors from which the company derives its value. This can include, but is not limited to, detailed analysis of current and forward-looking financial data and the nature and quality of working capital and cash flow; unusual or nonrecurring items of income or expense; analysis of cash receipts and expenditures compared to reported numbers; changes in accounting methods, policies and procedures or practices; analysis of business assets and inventory; reviews of transactions with related parties and existing contracts and terms with clients and vendors; and possibly assessments of the company’s ownership and management structure. However, a QOE goes further to normalize the target entity’s earnings before interest, taxes depreciation and amortization (EBITDA), which provides a more precise measurement of a company’s financial health as compared with similar businesses in similar industries and locations.
In general, removing interest payments, taxes, depreciation and amortization from earnings eliminates many of the factors that can distort a company’s true performance. Instead, EBITDA focuses on income and expenses related to a business’s core operations and its ability to continue making money in the future. It helps to clear out the clutter that can have a one-time impact on a business’s actual or normalized performance and cash flow, such as non-recurring transactions, and provide an apples-to-apples comparison of earnings for two or more business entities.
For example, consider a family-owned company with excessive owner compensation and salaries, bonuses and benefits paid to relatives it employs. The financial statements will reflect these costs as business expenses that reduce the company’s reportable earnings. However, these expenses will not necessarily transfer with an entity sale to a new owner. Rather, with a QOE report, sellers can recapture those expenses and add them back to income, thereby increasing the earnings they report to prospective buyers.
Why would a seller need a quality of earnings study?
Quality of earnings reports make mergers and acquisitions more transparent, helping buyers ask the right questions, understand their exposure to risks and make more informed decisions before closing a deal. They play an equally important role for sellers preparing their businesses for sale and looking to maximize both the value of their companies and the potential gain they can yield.
Business owners do not merely hire investment bankers or brokers to put their companies up for sale and wait for the offers to come in. Rather, sellers must conduct their own due diligence, preparing financial statements and supporting documentation to verify the accuracy of reported revenue and expenses. After all, deals most often fall apart when a potential buyer uncovers facts that contradict or disprove information provided by a seller.
A sell-side QOE helps to avoid this scenario by providing sellers with an opportunity to assess their businesses objectively, from the perspective of potential buyers, and identify problems before they list their companies for sale. Moreover, they give sellers the time to make changes and rectify those issues so that they can present their businesses to prospective buyers in the most positive light and gain greater control over the entire sales process.
How do I get a QOE and how much does it cost?
Quality of earnings studies are conducted by experienced, third-party accountants that have the knowledge and expertise to evaluate all of a business’s operational and financial aspects objectively and understand how they shape a prospective transaction. It is important to note that a QOE does not follow a check-the-box template of analysis and procedures. Rather, the scope and costs of a QOE will vary depending on the unique qualities of each particular deal.
Business sales, purchases, mergers and acquisitions require a significant amount of preparation, due diligence and keen attention to detail before a deal can be reached and a transaction can close. Time is a critical factor that can create risks and derail a deal. To minimize these dangers, savvy business owners should engage professional accounting firms to conduct quality of earnings studies before preparing their companies for sale. Outsourcing this due diligence to experienced accountants saves time and allows sellers to identify the operational and financial opportunities and challenges that buyers will rely on to define the viability of the business and the price they are willing to pay for it.
PKF Advisory has extensive experience helping buyers and sellers prepare for and evaluate business sales, mergers and acquisitions. If your organization needs assistance with merger and acquisition financial due diligence and quality of earnings studies as well as post-transaction earnout and closing net working capital analyses, please contact:
Daniel S. Hughes, CPA/CFF/CGMA, CVA