Understanding Quality of Earnings (QoE)

Are you sure that the business you’re trying to buy makes as much money as you think? Are you sure you are selling your business for enough?

The best way to find out is to perform a Quality of Earnings analysis (also known as a “QoE” or “Q of E”). I’m sure if you’ve even dipped one toe into the world of M&A, you have heard the term because this analysis is a critical step of any deal.

In this comprehensive exploration, we will explore the intricacies of QoE, understand its significance, and dive into how the analysis is performed.

What even is the Quality of Earnings?

A Quality of Earnings analysis is an assessment of the legitimacy, sustainability, and reliability of a company's reported earnings.? In simpler terms, this analysis aims to separate the core earnings potential of the business from the noise of any other non-core items in the Income Statement. While a company may report impressive earnings figures, QoE digs deeper to ascertain whether these earnings are a true reflection of operational success or if they are influenced by accounting maneuvers or one-time events. Thus, this gives the buyer a picture of what the Company would have earned if the buyer had owned the business for the past few years in a normalized environment.

Who should prepare a QoE Report?

Almost exclusively, a Quality of Earnings report is prepared by a third-party accounting firm, typically with a CPA designation. I highly recommend selecting a specialist as this is a very unique brand of financial analysis that requires a unique forensic toolkit and experience that can only be gained from performing this analysis on many transactions. Do not use your favorite CFO/Tax Advisor/Bookkeeper, even if they are a CPA.

When should I engage for a QoE?

From the buyer’s perspective, a QoE ensures the business has generated the amount of money the buyer has expected from their initial review. Typically, this process occurs after the Letter of Intent stage and I recommend one begins this process as the first step after an executed LOI, as findings during this essential analysis. Sellers also may engage firms to perform a Quality of Earnings before they go to market to maximize their proceeds. A sell-side QoE gives the seller the best idea of what their business is worth, how it will be evaluated, and what risks the buyer may perceive. Note: people in M&A often refer to the “QoE” as the entire report or the entire due diligence process, but the QoE is technically just one analysis within the broader umbrella of financial due diligence. For example, financial due diligence and the related report can include the following analyses: Quality of Earnings, Net Working Capital, Debt and Debt-like analysis, Customer Concentration analysis, Gross Margin analysis, and more.

Why is QoE Important?

• Financing/Underwriting: Often, both debt (banks) and equity (investors) parties will require a QoE analysis as part of their due diligence process.? Lenders and creditors assess the QoE of borrowers to gauge their creditworthiness and repayment capacity while equity investors ensure their understanding of the financial history is accurate.
• Valuation: When valuing a company for investment or acquisition, the quality of earnings plays a significant role. A company with high-quality earnings is generally valued more favorably.
• Informed Decision-Making: For investors, lenders, and acquirers, an accurate understanding of a company's financial health is crucial for making informed decisions.
• Risk Assessment: QoE is a risk management tool. Understanding the quality of earnings can highlight potential financial risks or uncertainties of the business that were not previously considered.

How is a QoE Performed?

QoE analysis involves analyzing and subsequently adjusting the target company's financial statements to provide a more accurate picture of its earnings quality. Without going too much into the process, this involves detailed trending of financial statements, inspection of supporting documentation, and inquiries with management. Some typical adjustment categories include:

• Normalizing Earnings: Adjustments are made to remove non-recurring, one-time, or extraordinary items. This could include expenses or revenues that are not expected to continue in the future, such as legal settlements, asset sales, or restructuring costs.
• Non-Operational Items: Removing income or expenses that are not related to the core operations of the business. For example, earnings from investments or losses from discontinued operations would be adjusted.
• Owner-Related Adjustments: Especially in smaller or privately-owned businesses, adjustments may be made for expenses that are more personal in nature than business-related, such as above-market salaries to family members or personal expenses charged to the business.
• Synergies and Cost Savings: In the context of an acquisition, pro forma adjustments might include synergies or cost savings expected post-acquisition. This could involve reductions in staff, consolidations of facilities, or other operational efficiencies.
• Pro-Forma Future Changes: Adjustments for known future changes that will affect earnings, such as new contracts, price changes, or planned expansions.
• Accounting Errors or Omissions: Corrections are made to any inaccuracies in the income presented.
• Accounting Policy Adjustments: If the company's accounting policies are not in line with industry standards or if there's a plan to change them post-acquisition, adjustments are made to reflect the impact of these changes on the earnings.
• Out-of-Period Adjustments: If an amount is corrected within the records of one period relating to a transaction that occurred in a prior period, then the amounts should not be considered in the more current period.
• Economic and Market Adjustments: Adjustments for changes in the economic or market environment that have a known and quantifiable impact on earnings.

Summary

Quality of Earnings acts as a financial compass, guiding stakeholders to the most accurate assessments of a company's financial health. Typical adjustments in QoE analysis help remove distortions and provide a clearer picture of a company's genuine earnings quality. By obtaining a QoE analysis, investors, acquirers, and decision-makers can make more informed, reliable, and risk-averse choices in the dynamic landscape of finance.

We are QoE experts - please reach out to learn more about our process and how we accomplish the most accurate, value-based QoE in the lower and middle markets.