Quality of earnings is a form of financial due diligence that provides an in-depth analysis of a company’s financial information. Quality of earnings analyses are often discussed as part of the process of buying or selling a business. In certain circumstances, lending institutions may require a quality of earnings analysis due to significantly greater borrowing needs or greater complexity in their lending arrangements.
Below is key information regarding what a quality of earnings report includes and why this analysis serves as a valuable tool when looking to buy or sell a business.
What does a quality of earnings report include?
The intent behind a quality of earnings report is to create an objective document that determines the accuracy and quality of historical earnings and assets, as well as the sustainability of future earnings and cash flows. The format of quality of earnings reports may vary, but at their core, they include an executive summary or highlights, quality of earnings analysis, income statement analysis, balance sheet analysis, working capital analysis, tax diligence (if required), and the build up of a variety of other information to support the report.
Quality of earnings reports are typically prepared by an independent professional as part of the financial due diligence phase in an acquisition or in preparation to sell a business. Reports include a summary of EBITDA (earnings before interest, taxes, depreciation, and amortization) before any adjustments, with management, due diligence, and proforma adjustments presented to come up with an adjusted EBITDA. It may also include adjustments for capital expenditures and identification of debt and debt-like items.
Additionally, reports include segmentations of revenues by customer, products/service type, and demographics. Reports also include historical information for revenues and operating expenses for the purpose of trend analysis , and identification of one-time or nonrecurring expenses that impact EBITDA. Reports also include key observations noted during the due diligence assignment, discussion regarding revenue recognition policies, and insights into pervasive management and internal control issues.
Why complete a quality of earnings analysis?
There are several reasons why completing this report is beneficial to potential buyers and sellers. It can allow sellers to objectively assess and evaluate the condition of their business, as well as understand issues that may come up during a buyer’s due diligence process. This allows the seller to be in a better position to discuss and address potential issues with a prospective acquirer if they arise.
Reports should identify non-recurring items, debt-like items, and other issues that could impact the sale price of the business. For sellers, this can minimize potential surprises and allow owners and management the time to correct or change identified issues and concerns when the business is marketed for sale.
Buyers perform due diligence to better understand the sustainability of cash flows, identify potential adjustments to EBITDA, and better understand accounting policies and potential issues. It allows the buyer’s advisors to work closely with the target’s financial team and provide critical feedback regarding the systems used, competency of the financial team, and quality of the financial information and monthly closing process, as well as other feedback. Findings from the quality of earnings report may provide buyers with the comfort they need to move forward with the transaction, or it can alert the buyer to red flags or information that may help them conclude not to pursue the deal.
When is the right time to request a quality of earnings report?
Determining the right time to complete have a quality of earnings analysis is a matter of judgement. In the case of a buy-side transaction, it typically begins after the letter of intent is signed; however, it is important that buyers line up their professionals ahead of time so that the process can begin immediately upon the LOI signing.
Sell-side transactions usually take two forms. The seller performs the quality of earnings one to two years in advance of putting their company up for sale in order to give them time to make improvements to their business and financial reporting information. Sellers may also complete a quality of earnings report just before the company markets its business for sale in order to provide potential suitors the report, and perhaps avoid the need for a buyer to perform its own quality of earnings analysis. Owners and management should consult with their professional advisors (i.e., their accountant, attorney, or consultants) to discuss the advantages and benefits of performing a quality of earnings prior to the sale of a business.
Preparation is the key to maximizing value when selling or buying a business, and the financial due diligence process can help avoid surprises by providing valuable information and analysis regarding a business’s financial information, financial trends, cash flow, and other information.
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