When preparing for mergers and acquisitions, getting a clear financial picture is critical to the decision-making process. For those buying and selling, it can make or break the deal. That’s where a Quality of Earnings analysis comes into play. The Quality of Earnings (QoE) analysis goes beyond the surface numbers to provide a detailed look at a company’s earnings quality, sustainability, and adequacy of the business operations, helping stakeholders make informed decisions.
What is a Quality of Earnings Analysis?
The Quality of Earnings analysis provides an in-depth analysis of a company’s financial health, sustainability of earnings, and accuracy. It focuses on factors like revenue recognition practices, use of estimates, expense management, and cash flow. Taking a closer look at non-recurring, non-cash, and non-operational income and expense items can reveal a more transparent picture of the company’s performance and value. These non-recurring items might distort the true picture of a company’s profitability. In today’s M&A world, nearly every buyer will use a third party to perform a QoE analysis. The seller of a company can have a QoE analysis done as well, providing them with an insight as to what the buyer will see. This gives the seller an opportunity to improve any deficiencies flushed out by this analysis.
A QoE analysis has numerous components and depending on the complexity of the company being analyzed, the QoE report will be around 75 to 80 pages. Here are a few components that are typically found in a QoE analysis:
Focus on Sustainability
A QoE analysis analyzes past performance to determine if earnings will likely continue into the future.
Non-Operational Expense or Revenue
One-time items that are not likely to reoccur are highlighted and eliminated as they will not generally happen again under the new ownership. An example of one-time revenue is income generated from the forgiveness of a PPP loan. The expense incurred from a lawsuit would likely not reoccur and therefore also be eliminated,
Test for Aggressive Accounting Practices
Generally Accepted Accounting Principles (GAAP) inherently use estimates and assumptions to portray a company’s financial position. For example, if accounts receivable management is poorly executed and the aging report shows several past due invoices, one would expect the accounting practice to book a reserve for bad debt. The QoE analysis will test the adequacy of that reserve based on historical write-offs. Another example is whether or not a company has recognized a contingent liability or recognized an impaired asset.
Focus on Cash Flow
Since “cash is king” understanding things like what cash is generated from operating activities is more important than cash from finance or investment activities. Another cash focus is how efficiently a company converts what they are selling into cash, which is measured by the cash conversion cycle in days. The working capital needs to measure the timing differences between when cash is collected from receivables and when it is paid out for payables. Understanding what the working capital needs are and how seasonal trends may fluctuate this need is important information for a buyer. Lastly, QoE analysis will generally tie cash bank deposits to the general ledger revenue and cash bank withdrawals to the general ledger expenses. This is called a “proof of cash” analysis.
Risk Assessment
Assessing potential risks and red flags is a key area of the QoE analysis. Some of the most common red flags are:
- Customer or vendor concentration risks
- Poor tracking of inventory and costs of goods sold
- Related party transactions
- High customer or employee turnover
- Disengaged management teams
- Data cannot be reconciled
- Lack of internal controls
What Are the Advantages for Each Side of the Negotiating Table
Let’s take a closer look!
Sell-Side
- Enhances Credibility – You’re providing potential buyers with a QoE report that demonstrates transparency and builds trust. It shows that you’re proactive in disclosing all financial aspects of your business.
- Identifies Value Drivers – The analysis highlights the strengths of your company’s earnings, allowing you to emphasize these points during negotiations. It gives you the numbers to back up your asking price.
- Prepares for Negotiations – Understanding any financial weaknesses ahead of time enables you to address them before entering discussions. It reduces the risk of surprises that could derail the deal.
- Speeds Up the Sales Process – A comprehensive QoE report can streamline due diligence by answering many of the buyer’s questions upfront, leading to a quicker closing.
Buy Side
- Uncovers Financial Risks – Spot red flags you might overlook, such as inconsistent revenue, aggressive accounting practices, or unsustainable earnings, helping you avoid overpaying.
- Validates Valuation – Make a more accurate valuation of the target company by adjusting earnings to reflect the true financial performance. Typically, a buyer will use the QoE data model to plug into their valuation model.
- Negotiate terms that reflect the actual financial health of the business because you understand what the quality of earnings report is telling you.
- Facilitates Financing – Lenders and investors often require a QoE report to assess the risk associated with financing the acquisition.
Each of these are key factors to consider when buying a business.
What is the Difference Between an Audit and a QoE?
Both an audit and QoE analysis can assess financial records. But they serve different purposes, and because of that, they use different methodologies to ensure you have the most useful information for an M&A negotiation. To compare the two, we’ll look at how they differ in four key areas.
Objective
Audit – Your primary goal is to ensure the financial statements are free from material misstatements and comply with accounting standards historically.
QoE Analysis – You want someone to evaluate the sustainability and accuracy of future earnings to inform investment decisions. Risk items found in a QoE analysis may be in compliance with accounting standards but may create deal issues or purchase price adjustments.
Scope
Audit – It’s broad in scope, covering all financial statements and ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) on an annual basis
QoE Analysis – This is much more detailed than an audit. It uses monthly data for a 3-to-5-year historical basis and the trailing twelve months (TTM) of the current year. This enables the QoE analysis to identify historical and current trends.
Users
Audit – for privately held companies It’s aimed at a wide range of stakeholders, including management & shareholders, banks, and vendors.
QoE Analysis – Specifically designed for parties involved in a transaction, such as buyers, sellers, and investors.
Outcome
Audit – The auditor reviews financial reports and provides their professional opinion on the financial statements.
QoE Analysis – An M&A specialized CPA expert provides a detailed report highlighting the adjusted earnings and potential risks or opportunities.
In summary, an audit assures that financial statements are accurate and compliant. The Quality of Earnings Report digs deeper into the quality and sustainability of those earnings to aid in transaction-related decisions and factors into the assessed value of the company.
Get a Comprehensive Quality of Earnings Report with DHJJ
Whether you’re on the sell or buy side, M&A is a major financial decision that no one should navigate without full awareness of earning quality. At DHJJ, we specialize in supporting companies who are considering buying or selling a company. We have years of experience preparing both buy-side and sell-side QoE analyses.
Our team of experienced CPAs and Certified M&A Advisors bring a wealth of experience to this critical business decision, along with industry-specific insights you can trust to understand the unique complexities of your business’ earning reports. Plus, you’ll get the ongoing advice and services you need to seamlessly complete the deal—and beyond.Don’t leave your next business deal to chance. Partner with DHJJ for a comprehensive Quality of Earnings analysis and ensure you’re making the most informed decision possible. Contact us today to learn more about how we can assist you in achieving a successful transaction.
