When it comes to potential mergers in business, numerous terms and acronyms are frequently used. As a business owner entering the transaction market, it is essential to be fluent in the language. Quality of Earnings (QoE) illustrates this as it is a term frequently mentioned when purchasing or selling a business.
So, what is a Quality of Earnings report, and what is its value? To begin, a QoE report is a type of financial accounting due diligence that analyzes the financial data of a business.
QoE is related to a transaction where a business is being bought or sold. Although a buyer may need to conduct legal, technology, operational, personnel, tax and other types of diligence, QoE is a specific exercise conducted during the financial due diligence.
What a Quality of Earnings Report Entails
An independent accounting firm conducting QoE examines a company’s financial and operational data focusing on EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is often considered a more accurate tool for estimating a company’s enterprise value when compared to other indicators like net income. It eliminates the effects of different capital structures and other business conditions that may change post-transaction, despite technically not being a financial measurement defined by U.S. GAAP. This measurement is also a good indicator of a company’s ability to generate operational cash flow.
In most cases, sellers present their company’s EBITDA in their offering material, often referred to as a Confidential Information Memorandum, or CIM. On the buyer’s side, an outside specialist, generally a CPA, will be hired to conduct financial due diligence and prepare a QoE analysis.
Quality of Earnings Analysis
The primary goal of a Quality of Earnings report is to evaluate the viability and integrity of past earnings and the realizability of future estimates.
A buyer should hire independent experts to undertake a QoE analysis after a letter of intent has been executed but before settling the ultimate purchase price and finalizing purchase agreements. A QoE analysis will help support the buyer’s investment thesis. A thorough and professional QoE study considers several factors.
Here is a quick list of factors to consider while choosing the right QoE research scope:
EBITDA calculates a business’s performance and profitability without taking into account the taxing jurisdictions and positions affecting reported income taxes, accounting policies influencing depreciation expense and financing decisions impacting interest costs. EBITDA is a metric that allows investors to compare profitability between varying types of companies and industries. It is important to remember that EBITDA does not necessarily reflect cash flow but profitability.
Buyers and sellers must also consider Historical Adjustments.
Types of Adjustment
There are generally three types of adjustments in regard to the QoE analysis. They are:
- Pro Forma Adjustment
- Normalizing Adjustment
- Due Diligence Adjustment
About Pro Forma Adjustment
Pro Forma Adjustments are restatements to earnings for the purpose of projecting the results of the last twelve months (trailing twelve months, ttm) of operations rather than the last calendar year (or reported fiscal year) results. Adjustments may pertain to cyclical effects and the impact of new, or discontinued, revenue streams.
Often, buyers start with a reported EBITDA and then add back different normalizing adjustments to get to adjusted EBITDA. Determining these modifications is crucial since it directly affects how much a buyer is likely to pay for the company.
These adjustments, in a nutshell, represent expenses that are now being recorded as part of the income statement (and consequently included in reported EBITDA) but will not be incurred going forward. Additionally, one-time, non-recurring revenue and expense items are included as normalizing adjustments.
About Due Diligence Adjustment
These adjustments are those that the due diligence team discovers. They may include accounting mistakes, the results of unrecorded or under-recorded obligations, or expense allocations from an affiliate.
The quantity of these modifications should help the buyer better understand the economic earnings. It will also shed light on the accuracy of the company’s data and the existing financial team’s capabilities.
A QoE will also consider adjustments related to generally accepted accounting principles (GAAP) policy application, particularly around balance sheet reserves. GAAP adjustments may include:
- customer credits
- uncollectible customer accounts
- inventory obsolescence
- accrual for environmental remediation
- contingency for litigation losses
- revenue recognition
Quality of Earnings Report Helps Pave the Road to Success
A QoE Report offers assurance and comprehension of a business’s operations and the figures upon which the transaction value is based. Realistic expectations of the transaction and confidence and understanding pave the way for successful transactions.
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