Why You Need a Quality of Earnings Report

Buying or selling a business can be an exciting, yet stressful, process. The seller may have dedicated a large part of their time, effort, and energy to growing a business they’re now saying goodbye to. Buyers are typically focused on a long list of due diligence items to ensure they can negotiate a fair price and avoid unwelcome surprises. Whichever side of the transaction you’re on, a Quality of Earnings (QoE) report can help you reach those goals.

What Is a QoE Report?

A Quality of Earnings report provides potential buyers or investors with more information about a company’s financial condition than can be gleaned from an audit report or traditional financial statements.

Financial statements tend to focus on historical numbers and can include nonrecurring revenues and expenses, overly aggressive accounting policies, related party transactions, and other items that cloud the target’s actual value. However, a QoE report is focused on the forward-looking performance of the business and its ability to generate cash flow now and in the future.

Sell-Side QoE Report

It’s not unusual for companies contemplating a sale to obtain a sell-side QoE report. This helps the seller understand how potential buyers might gauge the business’s financial health, spot problems that could potentially derail a transaction, and take corrective action to preserve or possibly increase the company’s value.

As the name suggests, a QoE report focuses on the “quality” or sustainability of a company’s earnings. A key metric in most merger and acquisition transactions is normalized EBITDA (earnings before interest, taxes, depreciation, and amortization). A QoE report starts with a company’s EBITDA, strips out unusual or nonrecurring revenues and expenses, adjusts owners’ compensation and related party transactions to reflect market rates, and identifies overstated or understated assets and liabilities.

Although any Quality of Earnings report can be customized to meet the seller’s needs, some other areas of focus may include:

  • Working capital and equipment needs
  • Key assumptions used in management forecasts
  • Information on technology, talent, client and vendor relationships, lease commitments, etc.

Enlisting the help of a professional to conduct a thorough sell-side QoE analysis can reduce the likelihood of having a deal fall apart or closing a deal with a final transaction price that is lower than the seller expected.

Buy-Side QoE Report

When buying or investing in a business, obtaining a copy of the target company’s audited financial statements is a good first step in the due diligence process, but financial statements don’t tell the whole story. Even a company with high net income and significant assets on the balance sheet can have cash flow problems and other issues that might not be visible at the surface level. A buy-side QoE report can help uncover those issues and prevent buyer’s remorse.

A buy-side QoE report can be customized to meet the buyer’s needs, but it typically includes several items, including:

  • Revenue broken down by product or service line or by customer
  • Analysis of revenue and expense trends
  • Segregation of one-time and nonrecurring revenues and expenses
  • Identification of inaccurate or inconsistent application of accounting policies and procedures
  • Issues related to the valuation of inventory and fixed assets
  • Key assumptions used in management forecasts

Buyers should have a QoE engagement performed as soon as they have a letter of intent because the information included in the report can help inform the rest of the due diligence process.

Benefits of a QoE Report

Obtaining a QoE report can benefit both sellers and buyers, but the goals are different for each party. For sellers, it helps determine a selling price and allows the seller to address potential issues before the buyer starts the due diligence process.

For buyers, a QoE report provides a better understanding of a potential target’s value and sustainability, and can help the buyer avoid a bad investment.

Although it’s not mandatory for a buyer or seller to obtain a QoE report, it can be an extremely valuable tool to help improve the chances of a successful close and ensure a fair transaction price for both parties.

What’s the difference between QoE reports and audits? Here’s a helpful summary.

How Holtzman Can Help

QoE engagements are a highly specialized area that should only be performed by experienced professionals. With diverse experience across many industries, Holtzman has earned a strong reputation for delivering customized transaction advisory services to help our clients achieve their goals and strengthen business value. With clients ranging from startups and middle-market leaders to large multinational conglomerates, we dedicate ourselves to delivering stellar results for our clients. Learn more about our M&A Transaction Advisory Services.

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