By: Rob Eisenstadt, CPA
Key Takeaways:
- Quality of earnings reports provide key insights into a business’s financial and operational performance as part of the due diligence process.
- These reports are becoming increasingly common, especially for M&A deals involving private equity buyers.
- Elements of a quality of earnings report vary depending on the circumstances of the company and can include EBITDA, variances in financial information, revenue/gross margin analysis, cash flow/working capital evaluation and more.
- Buyers should consider how current accounting policies/tax planning influence asking price along with potential changes in customer/product line impacts on sustainability.
The process of buying, selling or investing in a business involves much fact finding during the due diligence phase leading up to the transaction. Besides the basic financial statement and income tax information, buyers want to know the story behind the figures. That’s where a quality of earnings report can provide important insights.
A quality of earnings report is a third-party analysis of the selling company’s financial reports to determine how sustainable its revenues and earnings are, and how realistic its projections for future financial performance are.
As part of a pre-transaction due diligence process, quality of earnings reviews long have been standard for large companies and sophisticated buyers. But mid-sized and smaller companies, and even some first-time buyers, are increasingly including quality of earnings reviews in the due diligence process to protect their investments, ensure they are paying a fair price and realistically prepare to run the acquired business.
Why Are Quality of Earnings Reviews Important? Here’s an Example:
A buyer was considering purchasing a manufacturing company that dealt with metal and heavy steel. Similar to other manufacturers in that industry, the company sold a lot of valuable scrap. The due diligence team working for the seller had reported the revenue from the scrap sales in a “nonregular income” column on the financial statement, along with interest and other miscellaneous revenue sources. But it turned out the scrap revenue was a significant income source that should have been reported higher up on the financial statement on its own ordinary income line, as it affected the multiple that determined the sale price of the company. By discovering this during a quality of earnings review, the parties were able to negotiate a more realistic sale price.
A quality of earnings review can be requested by either a buyer or seller. For the buyer, the report provides independent analysis of a company’s financial and operational performance that can inform the decision as to whether to go through with the purchase and, if so, what price to pay. On the sell side, a seller or business broker may want an independent review of the accounting records to provide supporting data for a sales presentation to potential buyers.
What is Included?
Depending on the size of the company involved and the needs of both the buyer and seller, a quality of earnings review can be long and extensive or fairly short and focused. It’s best to find an accounting firm that will tailor the review to your specific needs, which will save time and make the investment more worthwhile.
Every business is different and the specific elements that are evaluated in a quality of earnings review should be tailored to yield the most insightful information for that company. Typical elements of a quality of earnings review for mid-sized and smaller companies include:
- EBITDA – earnings before interest, taxes, depreciation and amortization, which is a key indicator for all buyers to consider. It’s important to evaluate normal EBIDTA and adjusted EBIDTA.
- Variances in financial information.
- Revenue and gross margin by product, customer and distribution segments.
- Evaluation of cash flow.
- Review of working capital with an eye toward normal levels needed to sustain the business.
- Cash procedures such as proof of cash, which involves looking at the cash coming into a seller’s bank account and tying it to revenue reported on their financial statement. Similarly, we look at the cash that is leaving the company’s bank account and tie it to the operating expenses reported on the financial statement.
- Payroll reconciliation.
Generally, the goal is to look at key indicators to see what looks normal and what doesn’t look quite right so we can reveal the true strengths and weaknesses of the business.
Quality of earnings reports are becoming a more common feature of the due diligence process these days, particularly as more intermediaries such as business brokers become involved in M&A, even when the deals are on the smaller side.
Additionally, more M&A deals involve private equity buyers today, and private equity investors usually want to see a full quality of earnings report, including the EBIDTA schedule and working capital analysis.
Buyers sometimes push back on doing a quality of earnings review because of the cost. But if the insights gained from the review result in a lower sale price or yield useful information about how to cut operating costs once the business is acquired, the investment can be well worth the cost.
What Should Buyers Consider?
Once a buyer has committed to a quality of earnings evaluation, some questions to consider include:
- What kind of accounting policies are currently followed in the business, and what kind of tax planning have the owners done?
- What is the quality of the accounting records? A small company may be run in a way that everything is done for tax purposes. This can impact the asking price of the business.
- What kinds of EBIDTA adjustments are communicated on the books?
- Has there been a change in accounting, and if so, why? In one transaction recently, the seller was migrating to reporting based on GAAP, rather than income tax basis. The company does a lot of research and development and the quality of earnings review showed they had recently capitalized a large amount of R&D rather than take the immediate write-off they were entitled to. From the perspective of the buyer, this had the effect of inflating the company’s income, which affected the valuation of the business.
- What’s happening among the company’s major customers and their major product or service lines? Is the marketplace changing, or is the business changing? Some smaller companies took advantage of opportunities to expand their products during the COVID-19 pandemic, producing personal protective equipment such as hand sanitizer and masks. This boosted their revenues during the pandemic, but some of those revenues are declining now. Take a look at how sustainable the current revenues are.
If you are considering buying or selling a business and want assurance of the sustainability of its performance, contact your KRD advisor.
