The Power of a Quality of Earnings Report

If you’ve engaged in M&A activity, you’ve heard of a quality of earnings (QOE) report and know how vital a tool it is for assessing the opportunity and the viability of an investment.

A QOE goes far beyond what audited or reviewed financial statements deliver. Focused on normalized earnings and operational analysis of historical financial data, this report provides insights regarding important trends in operating results and assesses the strength and consistency of earnings, and the overall quality of a company’s financial information. Ultimately, a QOE helps stakeholders gain a comprehensive and transparent view of a company’s financial performance.

On the buy-side, investors and lenders rely on a QOE as a critical component of financial due diligence. A buy-side QOE is used by the acquiring party to:

• Provide investors with a comprehensive analysis of the target company’s financial position and earnings quality, focused on normalized earnings

• Identify potential risks and uncertainties that may impact the future financial performance of the company.

• Validate the business valuation, which is typically established from current or projected earnings.

• Develop a strategic plan for integration and operation of the company.

In the last 10 years, sell-side QOE has become more common and is a proactive approach to prepare a seller for a transaction. The benefits to an owner of a  sell-side QOE include:

• Enhanced transparency that demonstrates a commitment to accurate financial reporting.

• Identifying potential issues before buy-side due diligence, as issues discovered during due diligence can erode confidence in financial data, undermine negotiations, and delay the transaction process.

While QOE analysis can be tailored to the specifics of a company, the information typically presented in a QOE report includes:

Historical financial and operational analysis – typically the prior 2-3 years of financial statements are analyzed, along with the most current trailing 12 months. Analysis related to the historical financial statements and current operations includes:

• Significant accounting policies, including key estimates utilized in the financials.

• Operational trends.

• Key performance indicators and financial ratios – days sales outstanding and days purchases outstanding are common.

• Summary of customer and vendor contract terms and analysis of concentrations.

• GAAP adjustments and accounting misstatements.

Normalized EBITDA – EBITDA is presented along with normalization adjustments to arrive at an EBITDA expected to continue in the future.  Adjustments can include:

• Unusual, non-recurring transactions.

• Market adjustments for related party transactions, including owner compensation.

• Adjustments for known changes to the business model and economic environment that could impact the company’s operations, including facility costs, compensation, and revisions to related party relationships.

Working Capital Analysis – Quality of earnings reports include a calculation of historical working capital to be utilized to determine a negotiated target working capital in a purchase agreement. Adjustments found in the quality of earnings analysis can be made to the working capital calculation.

Proof of Cash – A proof of cash is often presented, particularly for unaudited companies.  The analysis typically reconciles revenues and expenses to receipts and disbursements on a bank statement. 

Projected Financial Adjustments – Projected financial statements are often utilized in corporate valuation.  Establishing adjusted, normalized historical earnings is key to developing prospective financial information. Adjustments found in a QOE analysis are applied to prospective financial information where appropriate. Deferred maintenance and required capital expenditures are identified and included in projections. 

In summary, a quality of earnings report is vital for stakeholders to gain a clearer understanding of a company’s financial health. Engaging in QOE analysis as a component of transaction due diligence provides the buyer confidence in the financial information provided and serves to support financial and strategic planning. For the seller, a QOE has become a standard when preparing for a transaction, providing transparency to a buyer and reducing the risk of surprises that can compromise the transaction process.