Quality of Earnings 101

Quality of earnings reports are the complete package of due diligence. Think of them as an audit-like report specifically for buyers of businesses. The QoE contains mission critical financial metrics that help the buyer gain insight into the target company's past, current, and future success.

Buyers are paying a multiple of EBITDA, SDE, or cash flow for a business. These are the exact numbers that the QoE verifies and delivers. If the EBITDA is less than expected by a percentage then the buyer has the proof to negotiate a lower price by that same percentage. For example, a 20% reduction in EBITDA on a $2 million deal would create a $400k savings. That would be the best ROI you've ever seen. A $20k investment in QoE - in this instance - created a 20x ROI.

We wish all sellers and brokers told 100% truths. But we don't live in that world. The QoE is important because YOU the buyer need to know the exact financial performance and condition of the business and be sure that the price you're paying for the business is fair. The QoE is your best option to evaluate all the items that are important when deciding to buy. We focus on EBITDA a lot but here are other things a QoE would catch so that you don't lose your investment: rises in key costs, revenue that is not likely to continue, temporary drops in costs that are not sustainable, recent shifts in accounting that juice the EBITDA, and the list goes on. The QoE covers you and makes you feel more comfortable that you're not being had.

A company’s Quality of Earnings is determined by identifying and removing any accounting trickery or irregularities that might misrepresent a company’s actual or normalized performance and cash flow. These irregularities might result from accounting choices, the business climate, or management decisions. They are not repeatable or sustainable over time, so they should not be a metric used to judge the profitability of a company moving forward. Quality of Earnings is established by calculating the percentage of income that is a direct result of higher sales and lower costs--and no other source.

A Quality of Earnings report will focus on a company’s income statement, but it will also drill down into the other financials to examine the condition and worth of assets on the balance sheet, consider the company’s systems of control, and inspect operations.

A Quality of Earnings can save you millions. And that’s not an overstatement. We've encountered countless deals that appeared straightforward on the surface but ended up being a disaster waiting to happen. Take a look at our Due Diligence War Stories for a taste of how a deal could have gone south without proper Due Diligence.

A Quality of Earnings report gives you the chance to take a look behind the scenes for yourself. Sellers are incentivized to represent their company as being as profitable as possible. Especially if you’re inexperienced in ETA, sellers and brokers will try every trick in the book to convince you that you’re making a great investment. I’ve seen it happen. A Quality of Earnings report helps you remain skeptical and allow the numbers to speak for themselves. It may even prevent you from making a multi-million-dollar mistake.

You can expect a QoE report to include an EBITDA with adjustments, Cash Proof, and Profit Per Product or Service.

EBITDA (earnings before interest, tax, depreciation, and amortization) with adjustments will represent the profitability of the company after removing the expenses that will not be moving forward with the company after the deal is done.

The Cash Proof will compare the company’s financials with bank statements. It analyzes cash receipts and expenditures compared to reported EBITDA

The Profit Per Product or Service will show if the margin has been consistent as the business grew. 

Simply put, the financial analysis in a QoE report--and the direction provided by due diligence experts like Guardian Due Diligence--is the information you need to confidently make an acquisition decision. 

QoE reports unearth risks that you might unknowingly be taking on with your deal. For example, you might not have a complete picture of client reliability. Will clients remain after the current owner steps down? A Quality of Earnings can measure this activity and prevent you from losing out after the deal is done.

Here are a few of the other common risks that a Quality of Earnings checks for:

Repeatability of operational systems to avoid any potential losses in production quality

Unusual trends and variances in internally prepared balance sheets and income statements

Significant and/or unusual accounting policies

Changes in accounting methods, principles, policies, procedures, or practices

Nature and extent of period-end closing adjustments

Reconciliation of items between general ledger balances and internally prepared financial statements

Unusual or nonrecurring items of income or expense

Transactions with related parties

Customer sales, concentrations, and backlog analysis

Key reserves and allowances

Reviews of account reconciliations, agings, and composition

By reviewing each of these factors, buyers are attending to the majority of risks that come with making an acquisition deal. It will give you peace of mind that your target company is a good investment in the long run. On the other hand, if a QoE report shows that a target company has misrepresented its future ability to earn, you can use it to negotiate a more reasonable price. Or you can avoid purchasing a non-cash-flowing business altogether.