The ebb and flow of revenue and expenses can often obscure the true measure of a company’s financial health.
When buying, merging or selling a business, one of the most critical aspects to evaluate is the company’s quality of earnings (QoE). The QoE influences not only the perceived value of the business but also the risk associated with the investment. High-quality earnings are indicative of a robust business model and a strong competitive position in the market. They reflect a company’s ability to generate income consistently over time, which is essential for long-term planning and investment.
The best way for CEOs and decision-makers to gain a detailed understanding of a business’s Quality of Earnings is by obtaining a QoE report. Administered by an independent third party, QoE reports are a cornerstone of due diligence during mergers and acquisitions (M&A), providing a magnified view of a company’s financial health.
In this essential guide, we’ll explain everything you need to know about QoE reports, from how they work to the benefits they provide for both seller and buyer.
What is a Quality of Earnings Report?
In basic terms, a Quality of Earnings report analyzes how a business generates income via an in-depth examination of its financial records. The objective of a QoE report is to compile a single document that presents the accuracy, sustainability and predictability of the company’s earnings.
QoE reports are perhaps the most important component of financial due diligence. They verify stated earnings before interest, taxes, depreciation, and amortization (EBITDA) and provide a clearer picture of a company’s financial health. QoE reports don’t just examine revenue, cash flow and profit margins, they review assets, working capital, debt structures, accounting policies, financial controls and other areas that affect the overall quality of earnings. Through expert analysis, they assess past performance and future projections while uncovering potential risks and opportunities that may not be apparent from standard financial statements alone.
What is Included in a Quality of Earnings Report?
Most QoE reports start with an executive summary that gives a snapshot of the findings, an analysis of the company’s earnings quality, and an assessment of the sustainability and accuracy of those earnings.
The core of a QoE report lies in its meticulous examination of the income statement, where it scrutinizes revenue streams to distinguish between recurring and non-recurring sources, ensuring that the earnings presented are not only genuine but also indicative of the company’s ongoing operations. One-time events or transactions that may temporarily inflate earnings will be identified to paint an accurate picture of the stability and predictability of future cash flows.
The balance sheet is another key financial document which is subject to rigorous testing. A QoE report will analyze the balance sheet to assess the quality of net assets, highlighting any discrepancies that may affect the perceived value of the company. Operating expenses will be reviewed to determine fixed and variable costs associated with core operations. A detailed debt and interest analysis can also help clarify the company’s debt structure and cost of capital. Ratio analysis is commonly applied to certain data sets to evaluate financial performance including the current ratio, gross profit margin and debt-to-equity ratio.
A QoE report also evaluates the working capital requirements and fluctuations to provide insight into the company’s operational efficiency and liquidity. Sales contracts, customer invoices, and related documentation may be analyzed to verify the consistency and reliability of revenue streams. Looking into accounts receivable and payable can also shine a light on the company’s cash conversion cycle and how effectively it manages its working capital.
Accounting policies are often reviewed to gain a better understanding of how revenue is recognized and to detect any aggressive accounting practices. Tax and regulatory compliance may also be assessed to identify potential issues or liabilities.
In addition to financial analysis, a QoE report may include a thorough review of the company’s business model, market position, and competitive landscape to assess the sustainability of earnings. Analysis of customer base, industry trends, key performance indicators (KPI) and product concentration are also common, as these factors can represent potential risks. For example, if a small business relies heavily on a few key customers, its profitability could be greatly affected by losing just one of those customers.
A QoE report will be rounded off with appendices that contain supporting data and detailed explanations of the methodologies used in the analysis. This ensures that the report is not only comprehensive but also transparent, allowing for informed decision-making.
What are the Benefits of a Quality of Earnings Report?
In mergers and acquisitions, the stakes are high. A misstep in the due diligence process can be extremely costly, affecting not only the success of the transaction but the overall future of the business as well. Whether buying or selling a business, the importance of obtaining a detailed QoE report from a reputable source cannot be overstated.
Selling a Business – It is now common practice for companies to obtain their own sell-side QoE reports before soliciting buyers. While these reports are generally paid for by the seller, the benefits they provide far outweigh the costs associated with them.
One of the main advantages sell-side QoE reports offer is the identification of expenses not counted in profit and loss statements which can be added back to the business’s earnings. These EBITDA add-backs include one-time costs and inflated expenses like excessive owner salaries or personal outlays. The buyer has no incentive to find these add-backs during their own due diligence, and if they do, they are under no obligation to disclose them. A sell-side QoE report will find all available EBITDA add-backs which can raise a company’s profitability and therefore, its value, maximizing the sale price of the business.
“Sell-side QoE reports also prepare the seller for buy-side due diligence, saving time and demonstrating commitment to potential buyers.”
Sell-side QoE reports limit the buyer’s ability to reduce the asking price, as the EBITDA and other financial information have already been verified by an independent third party. This allows the seller to maintain control of the M&A process and enhances the certainty of closing without lengthy renegotiations. They also provide the seller with a better understanding of their business from the perspective of the buyer, highlighting any issues that could disrupt the sale and allowing improvements to be made proactively.
Other benefits include the establishment of an advantageous net working capital target and the identification of underutilized assets or opportunities which can increase the value of the company. Sell-side QoE reports also prepare the seller for buy-side due diligence, saving time and demonstrating commitment to potential buyers. This can significantly speed up the M&A process and support a higher purchase price.
Buying a Business – Buy-side QoE reports are an essential part of M&A due diligence. Commissioned by potential buyers, they serve to validate the seller’s financial disclosures, allowing the buyer to determine whether the business is worth the price.
The main goal of a buy-side QoE report is to verify the stated EBITDA and facilitate a deeper understanding of the company’s financial health, including its cash flow, revenue, and profit margins. It also highlights any risks or liabilities that could affect the future performance of the business.
Strong financial statements can obscure the real value of a business. Buy-side QoE reports go beyond basic analysis of balance sheets and income statements to challenge the underlying data. For instance, a business might show a large net income, but if this is not supported by positive operating cash flow, it could indicate financial instability. Such insights are vital for decision-makers who need to understand the full picture before proceeding with an acquisition.
Buy-side QoE reports perform rigorous testing to ensure there are no inflated earnings. Through comprehensive review, they identify any discrepancies such as irregular inventory valuation or improperly capitalized expenses to determine the true financial position of the company. They also provide invaluable analysis of the target company’s accounting procedures and highlight operational improvements that can increase profitability. This information is an indispensable asset for the buyer which can greatly improve the transition to new ownership.
By obtaining a buy-side QoE report, the buyer can demonstrate a thorough understanding of the company’s operations and financials. Third-party analysis of normalized EBITDA and working capital requirements improves investor confidence and helps estimate and secure bank financing. Any issues uncovered in the report can also allow the buyer to negotiate more advantageous terms of sale.
Final Thoughts
Whether buying or selling a business, a comprehensive QoE report is essential for informed decision-making, providing a clear, unobstructed view of a company’s financial health. More than just a due diligence document – a QoE report is a roadmap for the transition of the business and the key to a successful M&A transaction.
For sellers, a sell-side QoE report enhances credibility, supports a higher valuation and highlights any areas that need improvement before the business goes to market. For buyers, a buy-side QoE report ensures the true value of the potential acquisition is accurately represented, with no surprises that could jeopardize the transition or long-term future of the business.
At NVS, our role extends beyond simply preparing the QoE report. It involves interpreting the data, providing strategic advice, and guiding business owners through the nuances of financial analysis. With services tailored to the individual, we empower our clients to make decisions that align with their long-term objectives, ensuring their business ventures are built on solid financial ground.
To learn more about our M&A advisory services and how they can help facilitate the sustained growth of your business, get in touch with our expert team today.
This article was written by the NVS Professional Corporation team, your knowledgeable Barrie and Markham accountants. The content is intended as a general guide for informational purposes only. For specialist advice tailored to your specific situation, please reach out to our expert team.
