3 Elements to an Effective Quality of Earnings Analysis

Business valuation has long been the harbinger of M&A transactions, but one aspect of valuation has been elusive until recently: a Quality of Earnings Analysis. Buyers have begun to assess a target’s quality of earnings to minimize the risks associated with business valuation. If future EBITDA profitability expansion is likely, a higher multiple may be warranted. Conversely, if industry and economic uncertainty are increasing a buyer must assess the potential downside to future earnings to establish the business valuation they are comfortable with.

Before buying or selling a company, it’s important to perform adequate financial due diligence to establish ample confidence the company is a viable strategic growth opportunity (transferable) and appropriately valued. A Quality of Earnings Analysis (QoE) is one component of financial due diligence that is typically completed along with a financial statement deep dive to reduce risks when establishing value.

Successful transactions require careful and thoughtful analysis to maximize value to a buyer or seller of a business. Seeking an experienced advisor to assist with financial due diligence is a key factor that will help to promote transaction success. M&A integration is an entirely different animal altogether.

A Quality of Earnings Analysis provides buyers, or sellers, in M&A transactions with a thorough assessment of the unique risks and opportunities of a target company’s based on financial analysis. Our goal is to validate or confirm a seller’s key financial performance such as sales, gross margins, EBITDA (before and after adjustments – more to follow on this concept), operating cash flows and working capital requirements.

A QoE analysis takes a deep dive into a company’s financial statements, highlighting how a company is generating value. This provides a detailed analysis of the key components of the company’s
accounting policies pertaining to revenue, costs and expenses.

3 Elements of Value

Every company must achieve a fit with market expectations relative to

Product
Organization
Finance

Many businesses suffer from inefficiencies and a lack of productivity. Both of these issues can significantly hinder profitability. Poor profit margins stifle growth. What can you do about it? Implement an effective business strategy alignment map to reach your full potential. We use a business strategy alignment model called an Alignment Map to assess a company’s fit in each of these three respects to help understand forward looking earnings risks.

Quality of Earnings analysis varies in accordance with client-specific needs. ALIGNMT is frequently called upon to provide QoE as follows:

Quality of Reporting Earnings and Cash Flow
Quality of Record Keeping and Accounting Systems
Appropriateness of Accounting Policies and Procedures
Quality of Collateral to Secure the Transaction
Potential for Off Book Assets and Liabilities
Quality of Internal Controls and Management Routines
Projections of Future Financial Performance

As part of the financial due diligence process, a QoE report complements an audit by concentrating on the income statement, determining the company’s earnings and cash flow potential. A QoE
analysis uses historical results, or EBITDA, excluding non-recurring revenue and expenses to account for “adjusted EBITDA”. This gives a better picture of what EBITDA should look like on a future focused basis.

The QoE analysis may identify issues related to:

Inconsistent application or changes in accounting policies or procedures between periods
Financial reporting policies that are not in accordance with Generally Accepted
Accounting Principles (GAAP)
Insufficient supporting documentation for management’s adjustments to EBITDA
Issues related to inventory valuation
Significant changes in allowances between periods
Changes with key customers
Inaccurate capitalization policies for fixed assets

What are the Benefits of a Quality of Earnings Analysis?

A QoE analysis and financial due diligence help uncover weaknesses in a company to identify risks for buyers and opportunities to increase value for sellers. A QoE analysis identifies business or financial reporting issues that may affect the company’s valuation. The results help avoid surprises for the buyer and seller.

ALIGNMT is experienced in performing due diligence for M&A transactions. We can offer any level of detail the buyer or seller is seeking. The scope will vary as agreed upon with the client.

An Quality of Earnings Analysis generally includes:

Company background
Shareholders or members
Organizational chart
Balance sheet accounts with details of receivables and agings
Inventory schedules
Accrual accounts
Income statement and balance sheet schedules and trends
Review of cost of sales, operating expenses and compensation
A quality of working capital adjusted to exclude cash and debt and adjustments, as needed
Quality of earnings with notes supporting adjustments

A Quality of Earnings report helps determine if the target company is a viable opportunity. Partnering with an experienced team like ALIGNMT makes for a smooth closing process.

How Does a Quality of Earnings Report Fit In To Due Diligence?

Quality of Earnings (QoE) assessment is a subset of the larger Financial Due Diligence process. QoE analysis is largely focused on financial statements and related support documents of the target entity, both from a historical prospective and with respect to projections. QoE analysis is geared to answer certain types of questions, several of which are listed here by way of example:

Do the historical earnings of the company accurately and completely represent the financial performance of the business, or are normalizing adjustments required for such items as nonrecurring, extraordinary, non-operating, contingent, and off-statement items and issues? QoE also seeks to identify any accounting errors.
Is the business as healthy as its balance sheet might suggest, or are there issues related to bad accounts, deferred expenditures, obsolescence, and unfavorable terms with suppliers, landlords, and creditors?
Are the company’s facilities optimal for future growth prospects?
What do auditors, vendors, and customers have to say about dealing with the company and the integrity of its management?
Do financial projections make sense relative to historical results, industry competition and trends, capabilities of the business, intellectual property rights, the economy, financial capacity, and timeframes?
Many more questions are asked in connection with a QoE examination. While conducting a QoE study, analysts are looking at such items as business risks, adequacy of financial and operating controls, quality of management reports and information, and management’s financial reporting practices with respect to such items as estimates and levels of reserves.

A QoE study presents the information provided by the seller, but normalizes and explains issues and variances such as those mentioned above. This process is linked to the examination of source documents in support of historical and projected financial statements and is conducted at a line item level of detail. Professional skepticism is a healthy practice when performing QoE analysis. With professional skepticism, certain risks that might otherwise be overlooked are often identified. An example might be the loss of a major customer that has only recently occurred.