Purchasing a Business – What Type of Report is Right for You?
At Smythe Advisory, we often assist parties looking to acquire businesses. As a team of chartered professional accountants and chartered business valuators, we will typically assist in one of:
- Financial due diligence in the form of a quality of earnings report (QoE Report); or
- Independent business valuation report
Many clients initially contact us looking for a valuation report but wind up deciding that a QoE Report is better suited for their needs. To help you decide which report is right for you, we have created a brief summary of the purpose of the two reports.
QUALITY OF EARNINGS REPORT
The objective of a QoE Report is to provide detailed insight into the target’s historical earnings. Traditional financial statements report historical earnings; however, they don’t provide the necessary details to give the purchaser insight into the likelihood of those earnings continuing. The QoE Report is designed to bridge that gap.
While there are common elements in most QoE Reports, there is no standard requirement. This allows a QoE Report to be customized to the specifics of the transaction and can focus on the areas of concern for the purchaser. Our goal is to assist the purchaser in better understanding the financial performance of the business to allow the purchaser to validate or reject their original investment assessment.
As most investment and pricing decisions are based on a multiple of historical earnings, the starting point for a typical QoE Report is determining “normalized earnings”. The vendor typically provides their own calculation of normalized earnings, so this portion of the QoE Report is designed to validate whether the purchaser should use that number when calculating the offer price.
Other common areas of analysis in QoE Reports are revenue and gross profit composition (e.g., sales by customer, product/service, geography, seasonality), purchases/cost of sales trends, payroll and operating expenses. The analysis is designed to provide the purchaser the level of detail necessary for them to assess the risks and opportunities of the business.
Once we have helped validate these areas of interest, the purchaser can assess whether they are still comfortable with their offer price. Our role is to provide the information necessary for the purchaser to develop their own conclusion on value. The findings from our quality of earnings report may lead to additional operational questions that can be further investigated during operational due diligence.
It is also common to prepare a working capital analysis as part of the QoE Report. This working capital analysis is used to form the basis of the working capital target in the purchaser agreement.
For more information about quality of earnings report, please refer to our previous blog article here.
The objective of a valuation report is to provide our independent assessment on the value of the business. Our valuation report must conform to the requirements of the Canadian Institute of Chartered Business Valuators’ practice standards. There are three different levels of valuation reports that can be prepared under the practice standards, each with a differing level of depth of analysis.
The most common level of valuation report that we prepare for purchasers is an estimate report. The practice standards define an estimate report as a report that contains a conclusion as to the value of shares, assets or an interest in a business that is based on limited review, analysis and corroboration of relevant information, and generally set out in a less detailed valuation report.
While the goal of the valuation report is to assess the fair market value of the business, the definition of fair market value includes certain assumptions and conditions that may not match the circumstances of the proposed transaction. Our valuation analysis is typically prepared from the point of view of a general purchaser. It usually will not consider the specific investment considerations of a particular purchaser.
As the objective of the report is to provide our conclusion of the business’ value, the majority of the report describes our valuation analysis. Although we consider similar financial metrics to those listed in the QoE Report (e.g., revenue composition, expense trends), the valuation report does not go into the same level of depth or detail regarding the historical financial performance of the business.
CHOOSING THE RIGHT OPTION FOR YOU
The best option for your situation will depend on the type of analysis that you have already performed.
Purchasers will typically approach us after they have already made an offer on the business and are in the due diligence phase. In this situation, the purchaser has already obtained some information from the vendor and performed their own analysis to arrive at the initial offer price. The offer price will be based on the vendor-provided information for historical earnings and general financial performance. Based on the purchaser’s knowledge of the business operations, they would have taken that information and determined an offer price after considering their own vision for the business going forward.
In this situation, the QoE Report is the best option. The goal of this stage of due diligence is to assist the purchaser in validating the assumptions they used in determining the offer price. The purchaser already knows what they are willing to pay if the underlying pricing assumptions are true, so our objective is to design our analysis to focus on those pricing assumptions.
On the other hand, some purchasers want to see our independent valuation assessment of the target business. This will usually be for one of two reasons. The first reason may be that they are looking for an independent sanity check on their own analysis. The second reason may be that it is a “friendly” deal between purchaser and vendor, so both parties are looking for a starting point for their negotiations. When we are engaged to prepare a valuation report, we will usually do so prior to an initial offer being made.
If you are in the process of purchasing a business, contact one of Smythe Advisory’s transaction advisors to see how we can assist you in performing your financial due diligence.