What Is A Quality Of Earnings Report?
Chris Barrett
Introduction
The term “QoE” pops up often in business acquisition, but what is a quality of earnings report?
When acquiring a business discerning the genuine financial health of a potential acquisition is a key part of good due diligence. This is the role of a Quality of Earnings report.
The Quality Of Earnings Report
A Quality of Earnings report is not merely a reflection of a company’s profitability. It’s a meticulous analysis that goes beyond superficial numbers, revealing the sustainability, consistency, and reliability of a business’s earnings. For a shrewd entrepreneur, the QoE is a guard against potential pitfalls and a guidepost to promising acquisitions.
Why You Need A Quality Of Earnings Report
Most companies selling for less than $5M do not have properly maintained financial statements. That being said, even properly maintained financial statements don’t tell the whole story of a company.
A Quality of Earnings report focuses on whether or not historical revenue and profit will continue into the future. That is what you really care about, because that future cash flow is what you will depend on to pay down your debt, feed your family, and grow the business.
Now, let’s look in more detail at what makes up a QoE report.
What Is The Scope Of A Quality Of Earnings Report?
A Quality of Earnings report is a consulting engagement and does not have any explicit standards from the American Institute of Certified Public Accountants (AICPA) on the exact processes or deliverables that should be included.
That being said, here are a few of the issues that analysis performed in a Quality of Earnings may uncover.
Improper Accounting
If a company is not adhering to Generally Accepted Accounting Principles (GAAP) they may not be properly representing their financial results.
Customer Concentration
Revenue is of a higher quality when it comes from a variety of different sources. If all of the revenues for your target are concentrated in one or two customers there could be substantial risk to you as a buyer should one of those customers leave after you purchase the company.
Supplier Concentration
If a company relies on a single supplier for key resources needed to perform operations then they are at risk of that supplier raising prices, or having supply chain issues.
Improper EBITDA Adjustments
Just because the seller and their broker say something is an add-back doesn’t make it an add-back. Trust but verify.
Related Party Transactions
If any employees, customers, or vendors are related to the seller in any way it is possible that the relationship or dealings between the business and those key stakeholders may be different with you as the new owner.
Revenue Or Expense Anomalies
Some of the expenses or revenues in the historical period may not have occurred in the “normal” course of business. For this reason they should be adjusted out.
Sustainability Of Future Earnings
The past is not guaranteed to repeat itself. You want to understand how likely earnings are to continue into the future with you as the new owner.
Divergence From Industry Benchmarks
If the company you are buying has significant differences from industry benchmarks you’ll want to understand what is driving the difference.
Recent Developments
If something has changed in the business recently such as hiring a new employee, new pricing from a key supplier, or the addition of a new product line you’ll want to know about it.
By uncovering these items, you’ll have a comprehensive view of the quality of the earnings you are buying.
Profits Vs Quality Of Earnings
The broker wants you to think the profits shown on the confidential information memorandum (CIM) tell you everything you need to know, but it will rarely tell the whole story. A Quality of Earnings report will. It dives into revenue consistency, expenditure trends, and filters out anomalies that could skew perceptions.
Starting With EBITDA
You’ll often hear the term EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) when talking about Quality of Earnings. It’s a foundational metric in the process and removes the distractions of taxes and other expenses.
However, a Quality of Earnings report will go beyond just showing a clear view of EBITDA over the historical period. It will include adjustments for non recurring items, differences in accounting methods, and proforma changes that are expected to occur with a new owner.
At Midwest CPA, our financial due diligence services analyze EBITDA, and other key financial data that will give you a normalized view of the financials so you know what you are buying.
What Are “Normalized” Financials?
When buying a business you want to know what financials will look like under normal circumstances with you as the new owner.
For example, if the current owner of the business you are buying is getting a 40% discount on the rent for their office because their brother owns the building you would want to “normalize” this rent payment by looking at the financials as if the business had been paying fair market value.
In short, “normalized” financials take a company’s earnings and strip away all the unusual stuff. Those things can make the company look more profitable than it usually is. By “normalizing” the financials, you get a clearer picture of how the company would be performing with you as the owner.
How To Read A Quality Of Earnings Report
A Quality of Earnings report may be structured in a variety of different ways. That being said, the below example shows a common layout that we use at Midwest CPA.
Management Adjustments
Oftentimes you will find on the CIM that management has already come up with their own adjustments to EBITDA.
Management Adjustment Reversals
During financial due diligence each of these adjustments will be reviewed and either validated or dismissed.
Reclassification Adjustments
These adjustments are for items that should not be included in EBITDA in the first place. For example, interest may have been included in total revenue and will need to be adjusted out.
Normalization Adjustments
These adjustments take out any revenue or expenses that are not associated with the normal course of business.
Pro-Forma Adjustments
These adjustments are for items that are for changes to the financials that can be expected under new ownership. For example, changes in a key service provider, or the inclusion of the salary for a new employee.
What's Run Rate Performance?
Run rate performance is a financial metric that predicts a company’s future performance based on its current financial data.
It helps you understand how the company is doing right now so you can make educated guesses about future earnings. This is important when reading a Quality of Earnings report because it gives you a clearer picture of what to expect down the road.
Audit Vs Quality Of Earnings Report
An audit is an attest service that provides an opinion on whether the financial statements that have been prepared by management comply with generally accepted accounting principles (GAAP) and have to be performed by a CPA.
A Quality of Earnings engagement on the other hand is a consulting engagement that one does not need to be a CPA to perform. Since it is a consulting engagement the scope and process of the engagement can be much more flexible than in an audit. Further, a QoE is much more focused on the sustainability of the earnings into the future than whether or not the historical statements align with GAAP.
Why You Need A QoE In Financial Due Diligence
If you’re thinking about buying a business, you can’t skip Quality of Earnings. It’s a key part of the due diligence process and helps you figure out what you should actually be paying for that business.
You need to have confidence in the numbers you’re being shown and a Quality of Earnings Report, prepared by a CPA who specializes in accounting for business acquisitions can help you avoid making a big mistake.
Limitations Of A Quality Of Earnings Report
Even a comprehensive quality of earnings report has its limitations. When you’re diving into what is a quality of earnings report, it’s crucial to be aware of certain factors that could distort the picture. Here are some things to keep in mind:
- The report is based on historical information
- The historical financial statements used in the analysis may be impacted by improper accounting policies
- It is possible for a QoE provider to allow bias to creep into their analysis
- Not all information may be available for precise analysis
By being aware of these factors, you’ll be better equipped to assess the quality of earnings and make more informed decisions in the acquisition process.
How Midwest CPA Can Help You
At Midwest CPA, we specialize in due diligence for business acquisitions. A Quality of Earnings report is an important part of our processes. If you’re considering acquiring a business, contact us today to discuss our due diligence services before committing to a deal.
Need some more tips, check out our blog, 9 steps on how to buy a business.
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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.
