Why a Quality of Earnings Report is Your Best Friend in Business Acquisitions
Chris Barrett
Imagine purchasing a business, only to later discover that you didn’t fully understand the business you purchased and as a result over-paid. This can lead to disaster for your business and even bankruptcy. Fortunately, this scenario can be more easily avoided with the help of a Quality of Earnings (QoE) report. In this article we are going to go over some of the ways a quality of earnings report can help make your acquisition a success.
Understanding What You’re Really Buying
One common mistake buyers make is relying too much on the financials provided by the seller. Here’s why that can be risky:
- Inaccurate Bookkeeping: Small businesses often don’t have perfect bookkeeping, leading to discrepancies between what’s reported and the actual financial health.
- Inflated Earnings: Sellers may inflate earnings intentionally or unintentionally.
To avoid these pitfalls, a quality of earnings report is essential. This report:
- Uncovers Discrepancies: It digs deeper into the numbers to reveal any inaccuracies or inflated earnings.
- Provides Clarity: It gives you a true picture of the business’s financial health, so you can make a smart, informed investment.
In short, don’t just trust the financials handed to you. Use a QoE to ensure you’re getting the real story.
Spotting Red Flags Early with a Quality of Earnings Report
A quality of earnings can help uncover potential red flags before you commit to buying a business. Here are some things that can be uncovered:
Customer Concentration
Supplier Concentration
Key Financial Trends
Illegitimate Add-Backs
Accounting Errors
Employment Trends
Net Working Capital Needs
Finding these issues early can save you from getting into a bad deal. By highlighting potential red flags, a QoE gives you the insights you need to make an informed decision, helping you avoid costly surprises down the road.
Ensuring You Don’t Overpay
The primary reason for conducting a quality of earnings analysis is that it directly influences the purchase price of the business.
EBITDA
One of the most critical components of a QoE report is the normalization of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). While EBITDA is a commonly used measure of a company’s profitability, it can be calculated differently depending on who is presenting the numbers. This variance can lead to misunderstandings about the true economic health of the business.
A QoE report aims to present an EBITDA that most accurately reflects the company’s economic reality, rather than just the numbers shown in GAAP-based financials. This “Economic EBITDA” is crucial because it provides a more realistic basis for predicting future performance, which in turn influences the valuation of the business. Without this adjustment, you might base your offer on inflated or distorted figures, leading to overpayment.
Debt Like Items
A QoE report also examines “net debt”—items that may not be classified as traditional debt but will result in cash outflows post-closing. Examples include transaction-related costs, deferred capital expenditures, prepayment penalties, and deferred revenue. Identifying these hidden liabilities is essential because they represent additional costs that could affect the overall value of the business. By accounting for net debt, the QoE helps ensure that these costs are reflected in the purchase price, so you don’t end up paying more than the business is worth.
Net Working Capital
Another critical area the QoE report covers is net working capital (NWC). If a business has less than the normal level of working capital at closing, you might need to inject additional cash to keep operations running smoothly. The QoE report helps you:
- Establish a working capital “peg”: This sets a baseline level of working capital that is expected to be maintained at closing.
- Understand financing needs: The report helps you anticipate any temporary cash needs that might arise.
- Plan for credit usage: It also forecasts when you might need to draw on a revolving line of credit.
By analyzing historical working capital trends, seasonal fluctuations, and the cash conversion cycle, the QoE report ensures that you’re not caught off guard by unexpected cash requirements. This information is crucial for setting a fair purchase price and avoiding future financial strain.
How Lenders and Investors Use a Quality of Earnings Report
A quality of earnings report is very helpful when you’re seeking financing or investment for a business acquisition. Here’s how it helps:
Builds Credibility: A QoE report provides independent verification of the business’s financials, which reassures both lenders and investors that the numbers are accurate and reliable.
Supports Valuation: By normalizing EBITDA and uncovering any financial risks, a QoE report ensures the business’s valuation is fair. This transparency makes lenders more likely to offer favorable loan terms and gives investors confidence in the investment’s potential.
Reduces Risk: The report highlights any red flags, such as hidden liabilities or working capital needs, reducing the risk of unpleasant surprises. This risk reduction is attractive to both lenders and investors, increasing your chances of securing the funds you need.
In short, a quality of earnings report strengthens your position when negotiating with lenders and investors, helping you secure the best possible financing and investment terms.
Benefits of a Quality of Earnings Report for Post-Closing Integration
A quality of earnings report can also help with post-closing accounting integration:
- Clear Financial Insights: It provides a detailed understanding of the business’s financials, making the transition smoother.
- Faster System Setup: With accurate data, you can quickly set up or integrate accounting systems.
- Improved Reporting: The QoE ensures reliable financial reporting, crucial for decision-making and compliance.
- Better Cash Flow Management: It helps anticipate and manage cash flow needs effectively.
- Strategic Alignment: The report allows you to align accounting practices with your business strategy.
In short, a QoE report streamlines post-closing integration, ensuring clarity and efficiency.
Conclusion
At Midwest CPA, the goal is to provide clarity and confidence in every business acquisition. Don’t leave your investment to chance—ensure you have the full picture before making your next big move.
Ready to take the first step? Click the button below to download our free Due Diligence Checklist and start your acquisition journey with confidence.
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.
