A quality of earnings (“QoE”) report forms part of the due diligence process in a mergers and acquisitions (M&A) engagement. The objective of the report is to assist investors and analysts in understanding the true profitability and overall health of a company, as well as the company’s ability to generate sustainable earnings in the future.
In a mergers and acquisitions transaction, a buyer will typically engage an investment bank or an accounting firm to perform the QoE analysis and issue a report. The company is given a customized due diligence checklist that will request several types of information and financial data that will be evaluated. Some common request items may include:
- Annual and monthly balance sheets, income statements, and cash flow statements with corresponding tax returns and remittances. This information will be used to calculate key metrics such as revenue growth, operating margins, and return on investment and assess the company’s historical tax compliance.
- Reconciliations of various balance sheet and income statement items are often requested to help the analyst understand the make up of accounts and any discrepancies between the company's financial statements and other data sources. Reconciliations may also include audit working papers, sub-ledger balances (aged receivables, inventory turns, etc.) and government subsidies (i.e., COVID related filings/subsidies).
- Reports prepared by the company's management, such as budgets, forecasts, and operational reports, can provide additional information about the company's performance and its prospects for the future. Buyers will review this information to understand one-time costs, synergy opportunities and potential operational improvements.
- Contracts and agreements, such as sales contracts, vendor contracts, and employment agreements, can provide valuable information about the company's operations, revenue streams, and costs. They can also help the buyer understand key workforce considerations pre and post transaction.
- Supporting documentation, such as invoices, purchase orders, and payment records, can help the analyst validate the accuracy of the company's financial statements. It can also assist a buyer in understanding and negotiating net working capital levels required in the business.
- Interviews with the company's management can provide valuable insights into the company's operations, future plans, and the underlying factors driving its financial performance.
- Third-party reports, such as industry reports, market research reports, and analyst reports, can provide additional information about the company's industry and market position.
The specific information requested will always be customized for the target and will depend on the nature and complexity of the company being evaluated. While financial and operational reporting is standard, buyers may want to conduct ESG (environmental, social and governance) audits, environmental studies, equipment/real estate appraisals, cyber security assessments, to name a few.
Having collected the due diligence information, analysts will review the information and consider the numerous factors that may impact the historical and future earnings, including the composition of revenue, the level of recurring revenue, the level of one-time or non-recurring items, and the sustainability of earnings growth. Specifically, they may do the following in a QoE analysis.
Review of financial statements
Conducting trend analysis of key accounts to identify key variances in costs and revenues and benchmarking the performance to industry standards as well as “stress testing” the company’s growth assumptions. For example, if a company has consistently increased its earnings over time, they may be seen to have a higher quality of earnings compared to a company that has seen volatility in their earnings, so benchmarking their growth is important.
Reviewing key accounts and reconciliations to ensure the accounts fully reflect all costs and potential liabilities (i.e., inventory write-offs, collectability of customer receivables, ensuring there are no off-balance sheet liabilities).
Analysis of non-recurring items
Identifying and adjusting for non-recurring items in the financial statements, such as one-time gains or losses, to obtain a clearer picture of the company's underlying earnings power. Non-recurring items can have a significant impact on a company's earnings. While they may appear to boost earnings in the short term, they can also be misleading and give a false impression of a company's true profitability. Often these one-time expenses or revenues will be normalized or adjusted. Examples of normalizations may include fair market value rent adjustments, non-market wages for key executives, one-time subsidies, lawsuits, etc.
Analysis of accounting policies and estimates:
Reviewing the company's accounting policies and procedures, as well as its use of estimates, to ensure that its financial statements adhere to the relevant standards and are consistently applied, noting management’s bias to overstate earnings.
A quality of earnings report on average can take 4-6 weeks to complete and forms part of the buyer’s due diligence reporting. It is an essential report for investors as it helps them understand the true profitability of a company and its ability to generate earnings in the future. A QoE can also be an extremely useful report for companies if they choose to undergo the due diligence process on themselves, increasing their ability to build investor confidence and attract capital.
Regardless of whether you are contemplating a sell side transaction or a capital raise, by focusing on the quality of earnings of your business, and ensuring your company is due diligence ready, owners can help ensure long-term success and stability in their companies.
For additional insights on quality of earnings and its value in the M&A process please contact, Candace Enman at cenman@welchcapitalpartners.com.
A quality of earnings (“QoE”) report forms part of the due diligence process in a mergers and acquisitions (M&A) engagement. The objective of the report is to assist investors and analysts in understanding the true profitability and overall health of a company, as well as the company’s ability to generate sustainable earnings in the future.
In a mergers and acquisitions transaction, a buyer will typically engage an investment bank or an accounting firm to perform the QoE analysis and issue a report. The company is given a customized due diligence checklist that will request several types of information and financial data that will be evaluated. Some common request items may include:
- Annual and monthly balance sheets, income statements, and cash flow statements with corresponding tax returns and remittances. This information will be used to calculate key metrics such as revenue growth, operating margins, and return on investment and assess the company’s historical tax compliance.
- Reconciliations of various balance sheet and income statement items are often requested to help the analyst understand the make up of accounts and any discrepancies between the company's financial statements and other data sources. Reconciliations may also include audit working papers, sub-ledger balances (aged receivables, inventory turns, etc.) and government subsidies (i.e., COVID related filings/subsidies).
- Reports prepared by the company's management, such as budgets, forecasts, and operational reports, can provide additional information about the company's performance and its prospects for the future. Buyers will review this information to understand one-time costs, synergy opportunities and potential operational improvements.
- Contracts and agreements, such as sales contracts, vendor contracts, and employment agreements, can provide valuable information about the company's operations, revenue streams, and costs. They can also help the buyer understand key workforce considerations pre and post transaction.
- Supporting documentation, such as invoices, purchase orders, and payment records, can help the analyst validate the accuracy of the company's financial statements. It can also assist a buyer in understanding and negotiating net working capital levels required in the business.
- Interviews with the company's management can provide valuable insights into the company's operations, future plans, and the underlying factors driving its financial performance.
- Third-party reports, such as industry reports, market research reports, and analyst reports, can provide additional information about the company's industry and market position.
The specific information requested will always be customized for the target and will depend on the nature and complexity of the company being evaluated. While financial and operational reporting is standard, buyers may want to conduct ESG (environmental, social and governance) audits, environmental studies, equipment/real estate appraisals, cyber security assessments, to name a few.
Having collected the due diligence information, analysts will review the information and consider the numerous factors that may impact the historical and future earnings, including the composition of revenue, the level of recurring revenue, the level of one-time or non-recurring items, and the sustainability of earnings growth. Specifically, they may do the following in a QoE analysis.
Review of financial statements
Conducting trend analysis of key accounts to identify key variances in costs and revenues and benchmarking the performance to industry standards as well as “stress testing” the company’s growth assumptions. For example, if a company has consistently increased its earnings over time, they may be seen to have a higher quality of earnings compared to a company that has seen volatility in their earnings, so benchmarking their growth is important.
Reviewing key accounts and reconciliations to ensure the accounts fully reflect all costs and potential liabilities (i.e., inventory write-offs, collectability of customer receivables, ensuring there are no off-balance sheet liabilities).
Analysis of non-recurring items
Identifying and adjusting for non-recurring items in the financial statements, such as one-time gains or losses, to obtain a clearer picture of the company's underlying earnings power. Non-recurring items can have a significant impact on a company's earnings. While they may appear to boost earnings in the short term, they can also be misleading and give a false impression of a company's true profitability. Often these one-time expenses or revenues will be normalized or adjusted. Examples of normalizations may include fair market value rent adjustments, non-market wages for key executives, one-time subsidies, lawsuits, etc.
Analysis of accounting policies and estimates:
Reviewing the company's accounting policies and procedures, as well as its use of estimates, to ensure that its financial statements adhere to the relevant standards and are consistently applied, noting management’s bias to overstate earnings.
A quality of earnings report on average can take 4-6 weeks to complete and forms part of the buyer’s due diligence reporting. It is an essential report for investors as it helps them understand the true profitability of a company and its ability to generate earnings in the future. A QoE can also be an extremely useful report for companies if they choose to undergo the due diligence process on themselves, increasing their ability to build investor confidence and attract capital.
Regardless of whether you are contemplating a sell side transaction or a capital raise, by focusing on the quality of earnings of your business, and ensuring your company is due diligence ready, owners can help ensure long-term success and stability in their companies.
For additional insights on quality of earnings and its value in the M&A process please contact, Candace Enman at cenman@welchcapitalpartners.com.
