What to Know About a Quality of Earnings Report in Pre-Sale Due Diligence
Pre-sale due diligence can help increase the valuation of the enterprise and eliminate surprises for the seller in a business transaction. The preparation of a quality of earnings (QOE) report will assist in making an efficient and effective due diligence process.
Understand the Enterprise Value
The enterprise value of the business typically is based on:
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Free cash flow (FCF)
- Revenue
- Some other driver which is known based on financial statements, and some multiplier of that value that’s specific to the industry and market conditions
Other factors specific to the individual business can contribute to the value of the business. Third-party QOE providers can get granular in analyzing the adjusted EBITDA during a QOE evaluation.
A QOE report is used to demonstrate the adjusted or normalized cash flow of a business.
QOE providers can identify issues that can affect the value of the business, make recommendations to fix or mitigate those issues, or, if they can’t be fixed or mitigated, explain in clear terms how they’ll affect the value of the business.
Benefits of a Quality of Earnings Report
If during the valuations process the buyer identifies something advantageous to the seller, the buyer is under no obligation to alert the seller. A QOE evaluation can uncover possible adjustments that can increase adjusted EBITDA as well as highlight areas of potential improvement.
Speed of sale is important, and time can be a challenge in a transaction. Pre-sale due diligence and a QOE report can help avoid having to renegotiate terms of the sale or reexamine the valuation if the deal isn’t executed quickly.
Businesses that invest in a QOE examination prior to a sale may find the resulting increase in valuation offsets the cost of the report.
Having a sell-side QOE will help:
- Maintain control of the sale process
- Improve the company’s positioning
- Increase transaction value
- Enhance certainty of closing
What Information Is Included in a Quality of Earnings Report?
A scope of due diligence procedures is customized to each client and transaction depending on factors like industry, market size, deal size, accounting complexities, and areas of special concern.
Reports typically include an analysis of adjusted EBITDA, and net working capital, net debt, a balance sheet and income statement, among others. Trend analysis, key performance indicator (KPI) analysis, customer analysis, vendor analysis, and headcount analysis are also common.
What Is the Process of a Quality of Earnings Report in the Sale of a Business?
Every transaction and every company is unique. Advisors adapt strategies and processes to reflect the goals and requirements of the deal team. A QOE typically takes four to six weeks to complete.
The sell-side advisors typically advise how the timing that the QOE should be completed to fit into the overall deal timeline. The process begins with the aggregation of source information, such as monthly financial statements. Then, the analysis and supporting schedules are built, which takes one to two weeks. Next, meetings are held to review findings, areas of concern, and required adjustments, which takes one to two weeks, and then the report is drafted, which usually takes an additional one to two weeks.
Should the process extend beyond a few months and the numbers become stale, the advisors can elect to roll forward all or part of the report to reflect the most recent financial activity of the business.
What Could Be Identified in a Quality of Earnings Report?
Types of common issues identified in a QOE report examination during pre-sale due diligence include:
- Non-recurring events and expenses that are unlikely to repeat can be removed from the financial statements, such as a lawsuit with substantial legal fees or judgments
- Non-operational expenses, such as the owner purchasing personal vehicles or vacations through the business
- Accounting errors, such as misstated financials, in which auditors compare to US generally accepted accounting principles (GAAP)
- Pro forma, such as an investment or purchase of equipment that improves efficiency that doesn’t impact the financial statements
- Assessment of recurring earnings and historical trends
- Adjustments to revenue and cost drivers
- Quality of balance sheet accounts
- Key risk areas such as customers, vendors, or key employees
- Financial terms and conditions of key contracts
- Normalized working capital needs
- In-depth explanation of accounting policies and procedures for complex transactions or critical estimates
- Summary of accounting software, financial reporting process, closing process, and IT systems
What Is a Quality of Earnings Report Versus an Audit?
Audits serve a different purpose than transaction due diligence. Items that are correct based on GAAP may still create deal issues or adjustments.
The traditional auditor isn’t an M&A specialist that will represent the seller through the close of a transaction.
Audits don’t focus on all issues that may be important to a buyer such as customer sales trends, cost structure, vendor, and relationships.
Audits cover an annual period and don’t show recent trends. Buyers rely on the most recent information, specifically the trailing 12 month (TTM) period for setting value and for debt financing underwriting, if applicable.
Auditors look at the numbers on an annual basis, while a QOE looks at adjusted numbers on a monthly basis and provides a more refined accuracy.
Indicators of Overall Earnings Quality
Businesses and potential buyers can assess the QOE report to gauge the sustainability and adequacy of the business’s operations. To determine the earnings quality, the following indicators could be assessed.
- Revenue trends
- Customer concentration
- Gross profit margin
- EBITDA margin
- Working capital
- Days sales outstanding/days payable outstanding (DSO/DPO)
- Annual recurring revenue
- Customer lifetime value
The Report Is Complete; Now What?
After the QOE report is complete, the provider can be a resource to help decrease the time needed for the buyer to understand the seller’s business and increase the buyer’s confidence.
The QOE provider will work closely with the investment bankers, attorneys, and sell-side advisors through the close of the transaction. The QOE provider is available to support management in answering questions from prospective buyers and support the financial positions arrived at in the QOE. The QOE provider will also assist with the data room, provide input to purchase agreement, and assist and advise in the preparation of the closing financial statements.
Next Steps
A sell side QOE can increase the value of a transaction for the seller. The QOE provider can help articulate the seller’s position on key risk areas such as customer concentrations, non-recurring revenue, timing adjustments, and earnings fluctuations. The clear picture of the earnings profile of the business can help the seller see how a buyer will view the company, informing strategic decisions about when to go to market, how to position certain situations, or how to improve key risk areas through the close of a transaction.
We’re Here to Help
For assistance with pre-sale diligence and QOE reports, contact your Moss Adams professional.