7 Benefits of Quality of Earnings Reports for Business Buyers
Chris Barrett
Introduction
Acquiring a business is a significant investment, and due diligence is critical to ensure a successful transaction. One step in the due diligence process is a Quality of Earnings (QoE) report. In this article, we explore seven key benefits of Quality of Earnings reports that every business buyer should know.
1) Levels the Information Playing Field
In any business acquisition, the seller naturally holds an advantage when it comes to information. They have intimate knowledge of their company’s financials, operations, and potential risks, while the buyer often has limited access to these details. A Quality of Earnings report addresses this imbalance by thoroughly analyzing the seller’s financial statements and conducting detailed interviews.
With a QoE report, buyers gain transparency into metrics such as revenue trends, cost structures, and profitability. This ensures that buyers can make informed decisions and reduces the likelihood of unexpected surprises after the acquisition.
2) Identifies Red Flags and Risks
A Quality of Earnings report dives deep into a company’s financials to uncover potential red flags that might not be immediately obvious. These risks can range from accounting errors to operational issues. Common red flags identified in QoE reports include:
- Accounting Discrepancies: Errors or inconsistencies from accepted accounting practices.
- Seasonality: Fluctuations in revenue or demand tied to specific times of the year.
- Concentration Risks: Over-reliance on a single customer, product, or revenue source.
- One-Time Events: Unusual transactions that may inflate earnings temporarily.
- Recent Financial Developments: Sudden changes in revenue or expenses that could signal instability.
By identifying these issues early, a QoE report equips buyers to address potential risks and avoid costly surprises post-acquisition.
3) Verifies the Quality of Earnings
The “quality” in Quality of Earnings is the key of any good analysis. You are not buying the historical earnings of the business. You are buying the ability of the business to produce future earnings. For this reason, you need to understand the quality of those historical earnings so that you have a reliable picture of cash flow that can be used to project into the future.
Key drivers of value—such as recurring revenue, cost efficiency, and operational scalability—are thoroughly examined to ensure the business’s financial performance is both accurate and sustainable.
4) Bridges Enterprise Value to Equity Value
One common misconception among buyers is equating a business’s enterprise value with its final purchase price. A Quality of Earnings report bridges this gap by factoring in key adjustments such as net working capital (NWC) and debt-like items.
For example, understanding the actual NWC requirements of the business can help ensure the buyer doesn’t overpay. Similarly, identifying debt-like items such as deferred revenue, or sales tax obligations are critical for arriving at an accurate equity value.
5) Strengthens Negotiation Power
When it comes to negotiations, the more you know, the better your position. A Quality of Earnings report provides you with the data you need to back up your requests, whether that’s adjusting the price or tweaking the terms of the deal.
For instance, if the QoE report reveals overstated earnings or significant risks, a buyer can use this data to justify a price adjustment or re-trade. The detailed findings of the report greatly increase the likelihood of success.
6) Assesses Accounting Practices
Accounting in small and medium-sized businesses (SMBs) can often be inconsistent, with processes varying widely depending on the company’s resources and expertise. A Quality of Earnings report highlights these accounting practices and identifies potential issues that may impact the business’s cash flow or performance.
For example, a QoE report might uncover discrepancies in revenue recognition or overly aggressive expense capitalization. By addressing these issues, buyers can better understand the company’s true performance.
7) Guides Post-Acquisition Integration
Buying a business is just the first step. Once closed, the real work begins. A Quality of Earnings report can help here too. By highlighting potential risks, operational inefficiencies, and areas for improvement, it can be used to help road-map post-closing changes.
For example, if the report points out weak inventory accounting practices, you’ll know to prioritize the implementation of a better system.
Conclusion
There are many benefits of a Quality of Earnings Report for a business buyer. It levels the playing field, uncovers risks, and gives you the insights you need to make informed decisions. Whether it’s helping you negotiate a better deal, bridging the gap between enterprise and equity value, or guiding post-acquisition integration, a QoE report is an important tool for buying with confidence.
If you’re looking for an accounting firm to assist with due diligence on your next acquisition book a call with an expert at Midwest CPA.
Frequently Asked Questions About Quality of Earnings Reports
The timeframe can vary depending on the size and complexity of the business, but it typically takes 2 to 4 weeks. Factors such as the availability of financial records and the scope of the analysis can impact the timeline.
The cost of a QoE report depends on the scope of the work and the complexity of the business being analyzed. For small to medium-sized businesses, the cost can range from $10,000 to $50,000, but larger transactions may require a more extensive analysis.
A QoE report is typically prepared by experienced accountants or financial advisors with expertise in mergers and acquisitions. Firms like Midwest CPA specialize in delivering QoE reports tailored to the needs of business buyers.
An audit focuses on ensuring compliance with accounting standards and verifying financial statements, while a QoE report evaluates the financial health and earnings quality of a business with an emphasis on sustainability and key drivers of value.
Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.
