When contemplating selling your business, it’s very common for investment bankers and other advisors to suggest getting a Quality of Earnings (QOE) report prepared prior to putting the business on the market. Even if the business has annual reviewed or audited financial statements by a third-party CPA, there are still many benefits in having a sell-side QOE prepared.
Here are six key benefits of a QOE report:
- Normalizes Earnings. A QOE report provides an independent, unbiased view of a seller’s true sustainable earnings by looking at its historical revenue, earnings, and adjusted EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization). Although a QOE report focuses on historical EBITDA, it combines this information with additional items provided by the seller to determine how the business may perform in the future. This is done by normalizing revenues and expenses that are either non-recurring or not part of normal operations to assess the true cash flows of the business.
- Flexibility. A QOE engagement’s procedures can be tailored based upon a seller’s specific needs. For instance, if a business is only planning to sell a certain division, a QOE report can carve out the necessary financial information so that a potential buyer can focus on the division-specific results and earnings. In addition, a QOE engagement can vary its scope or time period to fit the seller’s needs. It can be performed on a company’s annual fiscal year-end and include financial information based on a recent trailing twelve-month period. In many cases, having a QOE report that includes a trailing twelve-month period is important because it provides more timely information, especially if a transaction is slated for the later part of a year. This is different from audited or reviewed financial statements which are typically only prepared based on the company’s fiscal year-end.
- Trend Analysis. A QOE report focuses on the trends and drivers that ultimately increase or decrease revenues, costs, and the company’s overall gross profit. To fully understand these items, QOE engagements review information that would not be readily apparent from internally prepared financial statements. This information could be particularly important to a buyer as it can shed light on whether these margins or results are attainable in the future, or whether there are any potential addbacks or deductions required to EBITDA for any significant changes in the business such as discontinuations in product lines, vendor changes, or the removal of inflationary surcharges.
- Working Capital Analysis. Working capital is an important aspect of any transaction. When the business changes hands between owners, the new owner will expect an appropriate level of working capital to be maintained in the business on the day of the transaction, so the business can operate normally going forward and not require additional investment. As a result, a working capital analysis is necessary to help the seller and potential buyer define the amount of working capital necessary to allow the business to appropriately function.
- Identify Problem Areas. Another significant benefit of a sell-side QOE is that it can identify potential problem areas before a company goes to market and allow sufficient time for management to make the necessary corrective actions. Making sure that road bumps are identified and flattened can pay significant dividends for a potential transaction. Having a buyer identify issues during their own due diligence may create doubt and accordingly hurt the potential transaction value. Examples of potential issues include insufficient financial records, unrecorded liabilities, tax uncertainties, bad inventory, uncollectible receivables, and inconsistent accounting policies. Having a qualified firm perform the QOE will often provide the seller with valuable insight into how a buyer may view various aspects of the business, which the seller may not be able to see on their own.
- Concentrations of Risk. A QOE report will also identify concentrations of risk which may stem from significant customer relationships, major vendors, or even key employees. It will analyze and identify the amount of revenue generated from at least the top 10 customers. It will also identify revenue by product or service to ascertain whether the business has diversified product or service offerings. In addition, QOE reports will look for major vendor or supplier relationships which potentially pose a risk to the business’s success.
Without a doubt, there are various benefits of QOE engagements that are outside the scope of a reviewed or audited financial statement. Audited and reviewed financial statements provide valuable information but are based on strict accounting rules which may not be entirely reasonable for a specific business or industry. A QOE engagement, on the other hand, provides additional information, flexibility, and insight into the business that go well beyond accounting rules.
If you would like to learn more about sell-side quality of earnings engagement or have questions about the M&A process, please contact us.
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