Quality of Earnings Reports – A Useful Tool for Business Owners

We regularly get calls from people who are interested in either buying or selling a business. Purchasing or selling a business can be a daunting task, especially if you have never done it before. It is not uncommon for these parties to feel they need a business valuation to give them confidence that the price they are paying or getting is reasonable. While there are a lot of good reasons to get a formal valuation done, there are also circumstances when a different approach is warranted. That is the preparation of a Quality of Earnings Report (QofE)

The QofE report is the product of business due diligence. It is a valuable and necessary step for anyone buying a business and, in our view, equally important if you are planning to sell your business.

Quality of Earnings for Purchasers

In a typical M&A transaction the buyer will present the vendor with a non-binding offer to purchase or letter of intent. This document will lay out the general terms of the deal including the following:

  • What is being purchased (e.g., shares or specific assets of the company)
  • Purchase price or how purchase price is to be calculated
  • Payment terms
  • Date of closing
  • Working capital requirement at closing
  • Post-closing employment for shareholders
  • Important representations or warranties required
  • Timeline and scope of further due diligence

Often the offer will be based on a preliminary review of the financial statements of the vendor, but those statements don’t tell the whole story. In most cases, the buyer needs a lot more information before closing the deal to understand whether the business is worth the price being offered. Ultimately the purchaser is investing in a future stream of income. The QofE report will provide valuable insight into the risks associated with whether the stream of income will continue.

While every due diligence process is unique, it will generally start with a discussion with the purchaser regarding the risks and opportunities they perceive to be present. The scope of the due diligence assignment will be customized based on these discussions.

Common procedures performed will include:

  • Review of normalization adjustments proposed by the vendors and identification of other potential normalizing adjustments 
  • Analysis of sales and gross margin by customer, product line, geography, and month
  • Analysis of cost of sales composition
  • Analysis of historical purchases by supplier
  • Analysis of salaries and benefits by employee and position
  • Analysis of operating expense trends
  • Analysis of foreign exchange exposure
  • Identification of possible synergies or redundancies
  • Analysis of balance sheet composition
  • Analysis of historical working capital requirements
  • Obtain an understanding of accounting processes, controls, and systems

In order to perform these procedures, documents we will review include:

  • External accountant prepared financial statements, journal entries, and trial balances
  • Internal monthly financial statements and budgets
  • Vendor proposed EBITDA normalizations
  • General ledger data
  • Sales and projects data from CRM or ERP systems
  • Payroll ledgers
  • Monthly accounts receivable, accounts payable, and inventory listings
  • Completion of internal control questionnaires

The preparation of the QofE report is an iterative process that analyzes, refines, and improves the purchaser’s understanding of the business. The intended goal is to provide the confidence needed to close the deal at the price offered; however, it is not uncommon to uncover financial, operational, or other issues that put into question the quality of future cash flow from the business. In these cases, the purchaser and vendor may have to revisit the deal terms.

Quality of Earnings for Sellers

If you have decided to sell your business, the preparation of a quality of earnings report can be a great place to start.

At Smythe, we perform a quality of earnings analysis on every sales process we are engaged in before we go to market. The process involves doing a deep dive into your business operations to simulate what a sophisticated purchaser might do to evaluate the potential investment. The resulting report allows you to understand the value drivers of the business and assess any issues that might come up during the sale process. This understanding allows us to better defend value and keep the deal process moving forward. In some cases, we identify issues that when rectified may add significant value to the business. In these circumstances, the client may elect to delay the process to allow time for management to improve performance.

The benefits of the QofE analysis in terms of the sale process include:

  • Highlighting the key value drivers of your business with data to support the story
  • Giving the purchaser confidence that they understand your business
  • Reducing the purchaser’s perception of risk, which will lead to higher prices and better terms
  • Reducing the chances surprises will come up during the purchaser’s due diligence process that may lead to revised deal terms
  • Ensuring due diligence documentation is readily available for the purchase, which improves deal momentum and leads to faster closing times

Buying or selling a business is a complex process. It has been our experience that organizations that undertake proper planning and preparation are far more likely to have a successful conclusion.

The quality of earnings report plays an important role in any M&A transaction. If you want to know more please contact Alex Wong at awong@smythecpa.com or Gagandeep Ahluwalia at gahluwalia@smythecpa.com.