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A Quality of Earnings Report Offers Key Insights for Parties Considering a Transaction

May 1, 2023

Investors look closely at a company’s financial statements before making a commitment, as do buyers considering a business acquisition. While financial statements play an important role in the due diligence process, a quality of earnings (QoE) report may be needed to provide a clearer picture of revenue stability and future earnings potential.

Financial statements offer a snapshot view of a company’s earnings, but there are many reasons why the income shown at a certain point in time might not be sustainable over the long term. A QoE report provides a closer look at a company’s revenue, including the sources and types of income reported on financial statements. This helps eliminate potentially misleading influences — everything from unusually large transactions to the effect of changes in accounting methods — to uncover a more objective view of the company’s net earnings and its operational efficiency compared to similar businesses.

Scrutinizing the patterns and details of revenue, such as distinguishing cash from non-cash revenue and recurring from non-recurring income, puts the company’s current financial picture into more context and sheds further light on its likely performance in subsequent periods.

What’s in a Quality of Earnings Report?

A QoE assessment can uncover accounting problems with GAAP (generally accepted accounting principles) reporting, as can an audit. But whereas an audit typically focuses on the company’s balance sheet, a QoE report emphasizes recurring and substantiated earnings — typically EBITDA (earnings before interest, taxes, depreciation, and amortization). A QoE report also will show the users what the recasted or pro forma financial statements look like after adjustment.

The report typically includes an overview of the company and several sections that analyze its assets and net earnings, including an in-depth look at EBITDA and cash flow. In addition, assessors review assets and liabilities shown on the balance sheet and interpret relative business strength based on asset performance and capitalization structure.

There’s usually an assessment of liquidity that measures the working capital and operating expenses of the business. Understanding the normal working capital life cycle of a business is of paramount interest to all parties. This working capital analysis is a significant component of the engagement in helping both sides set a working capital target. This amount is set at closing to prevent either side from taking advantage and to make sure that the newly purchased or invested in company has enough working capital to fully operate on day one. The recurring working capital needs of a business can vary based on size, industry and a number of other factors.

The summary will describe any potentially problematic issues assessors found while preparing the report. The report’s conclusion may offer recommendations for or against moving ahead with a proposed acquisition.

What Are “High-Quality” Earnings?

Quality of earnings is a measure of risk. When more of the company’s revenue derives from factors other than the basics of higher sales and lower costs, quality of earnings is perceived as lower.

In general, high-quality earnings are stable over multiple reporting periods and afford the company ample free cash flow. Revenue that is less predictable, less sustainable, or less certain typically means lower-quality earnings. Every business is different, though, and there’s no bright line to divide high-quality earnings from others. The industry in which the business operates can also affect the nature of perceived risk of recurring or “sticky” revenues.

It’s also important to understand that lower-quality earnings may not indicate a problem or suggest that the business itself is of lower quality. Uncertainty can reflect a one-time cash influx that reflects well on the company’s financial strength despite its nonrecurring nature.

Common Reasons for Lower-Quality Earnings

Assessors often note in the earnings report specific accounting issues, events, or financial conditions that are not necessarily tied to the company’s revenue. These include macroeconomic factors, such as high inflation in the broader economy.

Some possible indicators of lower quality of earnings include:

  • Adjustments to net income
  • Aggressive or optimistic accounting and financial forecasting
  • Cash flow that remains flat despite higher income
  • Deferred repayments of debt
  • Earnings that are low relative to the cost of capital
  • High amounts of accounts receivable or other unrealized revenue
  • Low cash reserves
  • One-time revenue that is not likely to recur
  • Problems with GAAP reporting
  • Related party transactions
  • Stock buybacks
  • Deferred capital investments
  • Inconsistent US GAAP application
  • Supporting schedules and system reports that do not reconcile to the general ledger

Could a QoE Report Help You Achieve Your Business Objectives?

A QoE report is a valuable tool that can help buyers and sellers of private businesses settle on a fair price. Information contained in the report can also reveal potential risks and financial weaknesses that would make buyers and investors think twice, allowing current owners to correct course before putting their business on the market.

Conversely, a QoE report that reveals stable revenue and predictable earnings can facilitate a quick transaction by preemptively answering buyers’ questions and allaying their concerns.

Whether you’re considering an acquisition or preparing to sell your business, reach out to your CRI advisors to discuss the specifics of your transaction and whether a quality of earnings report is warranted.

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