The Vital Role of Quality of Earnings (QoE) Reports in Mergers and Acquisitions: Mitigating Risks to Time, Money, and Profitability

As the mergers and acquisitions (M&A) market continues to grow in Australia, with over $200 billion in transactions in 2023 alone, it's clear that businesses are leveraging M&A to expand and strengthen their market positions. However, without proper financial diligence, many deals fail to deliver expected returns, and one of the primary culprits is a lack of attention to the Quality of Earnings (QoE) report. This crucial document can help avoid costly mistakes, save time, and protect the profitability of both buyers and sellers.

Why the Quality of Earnings Report Matters

A Quality of Earnings report provides a deep dive into a company’s true financial health by separating sustainable earnings from one-off events. While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) is widely used as a key metric in assessing profitability, it can easily be inflated or misrepresented. In fact, a recent study found that up to 30% of Australian SMEs preparing for sale had overstated EBITDA by including non-recurring revenue or excluding certain costs.

The QoE report corrects this by normalising EBITDA, giving buyers a clearer picture of what they’re actually acquiring and allowing sellers to justify their asking price with confidence. But the risks of not fully understanding these financials can be substantial, impacting time, money, and future profitability.

The Risks of Neglecting a QoE Report

1. Time Delays

Without a thorough QoE analysis, M&A transactions can suffer significant time delays. Unexpected financial discrepancies often lead to prolonged negotiations or due diligence processes. Studies show that 20% of M&A deals in Australia experience delays due to unforeseen financial issues, which can stall market entry, integration plans, and competitive advantages. A properly executed QoE report can prevent these delays by surfacing potential issues early.

2. Financial Losses

Misrepresentations of EBITDA or unaccounted liabilities can lead to financial loss for buyers, often resulting in overpaying for the company. A PwC report highlighted that one in three buyers overpays for an acquisition by more than 10%, largely due to miscalculated financial metrics. Sellers can also find themselves at a disadvantage if buyers adjust the final price post-negotiation based on unanticipated financial findings. A comprehensive QoE report mitigates this risk by presenting an accurate, defensible picture of the company's financials.

3. Impact on Profitability

Post-merger profitability can be severely impacted if the deal is based on incorrect assumptions about earnings. A QoE report scrutinises revenue quality—identifying whether income is recurring or dependent on temporary factors, such as short-term contracts. Australian M&A deals where recurring revenue exceeds 70% have been shown to command 20-30% higher valuations, proving that long-term earnings consistency directly impacts the perceived profitability of a deal. Without this analysis, buyers risk acquiring a company whose revenue is unstable, impacting future cash flow and profitability.

How QoE Protects Your Investment

A properly prepared QoE report addresses the following key areas:

• Normalising EBITDA: Adjusts EBITDA for non-operational items like owner expenses, one-off gains, or unusual business events. This ensures that the company’s operational earnings reflect its true performance.
• Revenue Consistency: Differentiates between recurring and non-recurring income, helping buyers assess whether the company's revenue base is sustainable or temporary. This has a direct impact on future profitability projections.
• Hidden Liabilities: Identifies deferred liabilities, contingent liabilities, or underreported costs that can affect future cash flow. Many M&A deals have suffered financial strain due to liabilities not accounted for in the valuation.

In a market where 50% of M&A deals fail to meet their financial targets, ensuring you have a comprehensive QoE report is crucial to protecting time, money, and profitability.

The Australian Context: Increasing Demand for QoE in M&A

As Australia’s mid-market continues to attract foreign investment, demand for QoE reports has risen significantly. According to Deloitte, 72% of Australian dealmakers request a QoE report during due diligence, compared to just 58% five years ago. This trend is expected to increase as deal complexity grows and the need for accurate financial due diligence becomes more critical.

Immediate Action Points for Today:

1. Evaluate Your Current Due Diligence Process If you are involved in an M&A transaction—whether as a buyer or a seller—review your current due diligence practices. Does your process include a thorough Quality of Earnings report? If not, consider engaging financial experts to start one immediately.
2. Prepare a Financial Review Start gathering historical financial data and key operational metrics today. This data will be vital in preparing an accurate QoE report, ensuring that both the buyer and seller have a clear understanding of the company’s true earnings power.

Conclusion: QoE Reports—A Key to Successful M&A Deals

In a fast-evolving M&A landscape, a Quality of Earnings report is no longer just a nice-to-have—it’s a necessity. Protecting your time, investment, and future profitability hinges on a detailed, accurate analysis of a company's earnings quality. By focusing on the true operational performance of the business, QoE reports help mitigate financial risks and ensure that both parties in the deal have aligned expectations. Whether you’re a buyer looking to safeguard your investment or a seller aiming to justify your valuation, investing in a QoE report will ensure your transaction meets its financial and strategic goals.