For prospective buyers including search funds eyeing a business transaction, deciding which company to acquire is often easier said than done. Buy-side due diligence is essential to assess the financial health of the target company, and an integral part of this process is the preparation of a Quality of Earnings (QofE) report. A QofE offers comprehensive evaluation of a company’s financial statements and tax positions, with a particular emphasis on Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)—a metric widely regarded in most industries as a more relevant indicator for determining a business’s enterprise value compared to other metrics, such as net income. In this article, Ryan Turbes, CPA, Partner in Boulay’s Transaction Group, defines the role of QofE analysis in the business transaction process and how it provides buyers with invaluable insights for successful acquisitions.
Understanding Quality of Earnings Analysis
A QofE analysis is a holistic assessment conducted by an accounting or consulting firm with the primary objective of evaluating a company’s historical earnings accuracy, sustainability, and the feasibility of future earnings. Unlike an audit, it does not offer an opinion but aims to uncover insights that can impact the value of the business. A typical QofE report is comprised of an analysis of adjusted EBITDA, net working capital, net debt, balance sheets, income statements, trend analysis, key performance indicators (KPIs), customer and vendor analysis, and headcount analysis. The report delves into the financial health of the business, primarily identifying areas that can be improved. In contrast with audits, which follow GAAP and focus on annual periods, QofE reports show a holistic, monthly perspective on financial reporting. This is valuable for buyers, including search funds or ETAs who are typically interested in broader information not included in audits, such as recent customer trends, cost structure, and external relationships.
Quality of Earnings Process
The QofE analysis process is adaptable to the unique needs of each transaction and company. It involves data aggregation, analysis, meetings to discuss findings, and report drafting. Most transactions necessitate some form of QofE analysis, either for the buyer’s internal assessment or due to the requirements of investors and financial partners. If the exclusivity process extends beyond a few months, it can be updated to reflect the most recent financial activity. A transaction advisory team then makes recommendations to the buyer, using the appropriate information to solidify their position and ensure sound decision-making.
Benefits of a Quality of Earnings Report
A QofE report is a powerful tool for buyers as it uncovers potential adjustments that can increase adjusted EBITDA, thus lowering the EBITDA multiple, which can lead to a more favorable transaction value. It also streamlines the due diligence process, reducing the need for time-consuming renegotiations and often offsetting the cost of the report, making the deal more advantageous. More broadly, a QofE report supports the buyer’s decision and provides the necessary information for added confidence in the overall sustainability of the target. Proper analysis of the QofE indicates whether or not the reported earnings are the result of extraordinary circumstances and demonstrates to the buyer the viability of the target company for years to come.
Indicators of Earnings Quality
QofE reports enable businesses and potential buyers including search funds to assess the sustainability and health of the company’s operations. Key indicators considered include revenue trends, customer concentration, gross profit margin, EBITDA margin, working capital, annual recurring revenue, and customer churn. Earnings must show free cash flow and sustainability of the target, as accounts receivable can show value as recognized but not yet realized. Lower EBITDA doesn’t necessarily mean poor financials but could point to higher associated risk in the transaction.
Helping You Get There…
After the QofE report is complete, the provider becomes a valuable resource for the buyer in understanding the seller’s business. An experienced transaction advisory team also collaborates with all involved parties throughout the transaction process, including investment bankers, attorneys, and sell-side advisors, assisting with data room management, purchase agreements, and the preparation of closing financial statements.
A Quality of Earnings analysis sheds light on the financial health of the company, identifies areas for improvement, and provides comfort on the purchase price of the transaction. With a QofE report in hand and a trusted financial due diligence advisor by their side, buyers including search funds can navigate the complex M&A transaction process with confidence and secure the best possible deal for their business portfolio. Connect with a member of Boulay’s transaction advisory team to learn more about how we’re dedicated to helping you get there.