A quality of earnings report—QoE or QofE—is an important financial document written by a team that includes an independent accounting firm. The report provides an extensive review of a company’s operating and financial information and emphasizes the “earnings before interest, taxes, amortization, and depreciation” (EBITDA) metric.
The metrics presented in the QofE report are considered a stronger indicator for determining a company’s value than other metrics like net income. For this reason, QofE reports are fundamental for companies considering mergers and acquisitions.
What Is a Quality of Earnings Report?
A quality of earnings report is a document that provides detailed information about a company’s financial position, its revenue, the nature of this revenue, and how sustainable the company’s earnings are. This document shows potential buyers how strong of an investment a given business would be (were they to purchase it) and is an important step in the due diligence process related to private acquisitions.
Why Is a Quality of Earnings Report Necessary?
A quality of earnings report is necessary because net income alone doesn’t accurately indicate a business’s financial performance. For example, if a company reports a large income but negative operating cash flow, its financial health may not be all that it seems. A QofE report also assesses how the company accumulates its revenue—for example, cash or non-cash, recurring or non-recurring.
A quality of earnings report is also necessary because a company’s income statements don’t list many key details a prospective buyer would want to know. The breakdown of cash sources outlined in a QofE report is therefore very important. If a company reports a positive net income but has poor-quality earnings, it could be considered a riskier investment than what the company’s financial statements first suggested. Assessing a company’s cash sources can affect whether or not a prospective acquirer decides to proceed.
Who Can Produce a Quality of Earnings Report?
Florida CPA firms that offer transaction advisory services can help you with due diligence by conducting a thorough assessment of your or another company’s financial health and any risks associated with it. This allows you to make informed decisions.
What Are the Benefits of a QofE Report?
If you are considering selling your company, you may benefit from a sell-side QofE report. Some of the benefits include:
- Exposing accounting issues: It’s fundamental to identify any flaws or inherent structural issues in your accounting process. During the process, your financial statements will be checked for compliance with generally accepted accounting principles (GAAP).
- Expediting the transaction process: Your company will be fully ready for a sale after preparing a QofE report as it will help you identify your strengths and allow you to address any potential issues. With the information in the QofE report on hand, you can meet prospective buyers professionally and encounter fewer surprises along the way. You may also be able to move the process along quicker and minimize any post-letter of intent delays.
- Controlling processes: Generating a QofE report allows you to anticipate how a buyer might react to the company’s adjusted EBITDA. Then, you can confidently establish an optimal sales target without fear of being blindsided by an underwhelming QofE report.
- Enhancing credibility: Allowing a third-party review of your financial statements shows that you are honest and transparent in your dealings.
- Avoid future price renegotiations: Setting a fair sale price that’s aligned with your financial metrics reduces the chance that the buyer will return with a lowball offer.
Studies estimate the failure rate of mergers and acquisitions to be around 50%. This failure can be attributed to many possible causes, but poor due diligence certainly doesn’t help.
What Does a Quality of Earnings Report Include?
QofE reports can have different sections depending on the nature of the business and any supplementary or additional information the company may wish to include. However, five main sections feature in nearly every report. These are:
- Executive Summary: This section offers an overview of the business by listing details such as the company’s location, when it was founded and by whom, the executive hierarchy, the products and services the company offers, its customer base, and any other relevant information.
- Income Statement Analysis: Perhaps the most important part of the report, the income statement demonstrates the company’s earnings. The Income Statement analysis takes into consideration adjustments that should be highlighted to a prospective buyer/seller as there can be one-time expenses, or for small businesses, can also include expenses that would be called into question as being necessary. Ultimately, a re-forecasted measure of income, utilizing the EBITDA formula, is presented.
- Quality of Net Assets (Balance Sheet): This section reviews and assesses the balance sheet, setting out the company’s assets—what the company owns—and its liabilities—what it owes. This report reveals the strength of the balance sheet in light of the company’s working capital, the performance of company assets, and the capitalization structure.
- Working Capital Analysis: This shows the company’s liquid assets. A financially healthy company will—generally speaking—have a healthy number of assets.
- Quality of Earnings Analysis: This section functions as a conclusion of sorts. The assessor summarizes the findings of the report, flags potential issues, and makes recommendations about whether or not the acquisition should be pursued.
Who Should Be On the QofE Team?
The following people are generally on the QofE team:
- The business owner or CEO: The business owner will have valuable insights into the company’s financial performance as well as its history, operations, and potential for growth.
- An M&A advisor or investment banker: They can guide the process, pinpoint potential buyers, and negotiate the sale of the business.
- An accountant or financial analyst: This person will carry out the QofE analysis, analyze the company’s monthly financial statements, and suggest any modifications to the financials to paint a more accurate picture of the company’s earning potential.
- An M&A lawyer: Your company will require expert legal advice regarding regulations and compliance that you must address before the sale.
- A tax specialist: A CPA can help you structure the sale in such a way as to maximize your after-tax proceeds.
- A management consultant or industry expert: Somebody who understands the ins and outs of the industry can identify the areas of the business that perform well and have growth potential. This could attract potential buyers and increase the business’s perceived value.
How Long Does It Take to Produce a QofE Report?
It may take longer or shorter to complete a QofE report depending on several factors. However, factor in at least four weeks to complete the process.
Increase Your Purchase Price with Transaction Advisory Services
Selling your business isn’t an easy decision, so it’s important to do it right when the time comes. Getting support from financial advisors will streamline the process and gives you access to expert advice.
Taking the proactive step of requesting a quality of earnings report puts you on the front foot when selling your business and also puts you in good stead to make the best possible deal. With an expert CPA by your side, you’ll have the tools you need to fully understand the details of the deal, optimize your business opportunities, and stay compliant at every stage.