What is Quality of Earnings?

In the process of selling a middle market private company, the buyer will eventually seek to validate the cash flow and financial information presented to them in the marketing materials; the information typically used to value the business.  Once the Letter of Intent (LOI) is signed, the buyer will commence due diligence, which is a confirmatory process for ensuring the data they’ve received regarding the business to-date is accurate and correct, and to more fully understand all aspects of the company.

Traditional due diligence includes scrubbing the financial information to understand the timing and nuances of the business’ revenues, expenses, cash flow, accounting methods and practices. As part of this analysis, buyers will typically undertake a quality of earnings (QofE) analysis or assessment, usually conducted by an outside accounting firm.

Many transactions are structured as a multiple of EBITDA, which is further adjusted for the impact of any nonrecurring or nonbusiness items reported in the historical operating results of the target. Adjusted EBITDA typically serves as the foundation for buyers in building their overall valuation model and this model drives the determination of the ultimate purchase price. When transactions are based on adjusted EBITDA it is critical to assess the true baseline earnings power of the company.

Audited financial statements primarily focus on the balance sheet to ensure that the beginning balances and the ending balances of all the assets and liabilities are materially correct. This is not to imply that there is not scrutiny of the income statement by the target’s auditors, but that is generally at a much higher level than is needed to adequately understand a seller’s business model. In most cases, there can be period-to-period changes in earnings and other fluctuations that are not revealed by an audit and may be of significance to a deal. As mentioned above, business valuations and some transaction financing are predicated on a certain level of available cash flow based on the core earnings of the underlying business. Although a review of audit working papers is often a part of a QofE assessment, it is only used as a starting point for further, more forward-looking analysis.

A QofE assessment is conducted to fully understand the historical revenues, cash flow, and earnings. Although one benefit of such an assessment includes the clarification of any accounting anomalies, a thorough assessment should result in a number of other benefits, including:

  •    Identification of concentrations of risk, including reliance on large customers, sole-source vendors, or key employees
  •    Quantification of the effect of trends in product pricing, volume, and sales mix on the target company’s revenues and gross margins
  •    Analysis of the working capital needs of the business to better understand operating cash flows
  •    Identification of unusual and nonrecurring items of income and expense that need to be removed to assess the underlying cash flows of the target going forward
  •    Comparison of accounting policies used by the seller with those of the acquirer to better understand the effect of the sale or acquisition

The QofE assessment also seeks to validate normalization adjustments and EBITDA add-backs presented by the seller.  A byproduct of the process usually includes highlighting variances or non-conformance to GAAP (generally accepted accounting practices).  As insinuated by its name, the QofE report will provide insight into the quality of revenues and cash flow.  Quality can be measured a number of ways and in terms of the underlying nature of these values – – such as the concentration of revenues, cash flow and accounts receivable from a few customers.  Another underlying characteristic is seasonality… which is variability of revenues and cash flow based on a cycle within the fiscal year.

Even though a QofE assessment focuses on the historical performance of the selling company, its true purpose is to gain insight into the target’s future operating results and cash flows. This is seldom the focus of a traditional audit.  Valuation of privately held companies is almost always based on future cash flow.

While we operate primarily as M&A advisors from Raleigh, North Carolina, in today’s US market, proactive sellers are choosing to preempt the buyer’s QofE work with their own assessment of their financial performance, and make corrections to or restatement of financial information before going to market.  At a minimum, sellers are identifying areas that will likely to be of concern to a buyer, and developing a credible explanation and presentation of their issues so as to eliminate surprises. Many private companies do not have audited financial statements and use either modified cash accounting or a loose version of GAAP … thus creating predictable accounting problems when attempting to present fully GAAP compliant statements.  The most common issues are we encounter with financial statements of technology, B2B service businesses, manufacturers and distributors include:

  •    Incorrect revenue recognition
  •    Expensed CAPEX for tax purposes vs. GAAP depreciation
  •    Lack of accruals for PTO and payroll
  •    Poor or no tracking of customer deposits or deferred revenue

 

[1] Source: Middle Market M&A: Handbook of Investment Banking and Business Consulting; John Wiley & Sons 2012