Insights

Business Owners Increasingly Rely on Quality of Earnings Reports to Sell their Companies

Business sales, mergers and acquisitions are a delicate balancing act between sellers, who want to maximise the amount of money they receive for their business, and purchasers, who want to make sure the price they pay is in line with the reality of the company’s actual operations and financial performance.

QOE reportA quality of earnings (QOE) study, which takes a deep dive into a target company’s financial performance and profitability in order to assess a stream of predictable future earnings potential, has been a significant component of a buyer’s due diligence process. In today’s active deal climate, however, sellers seeking a competitive edge are proactively employing independent accounting firms with M&A transaction experience to do QOE studies before putting their business on the market. This helps to speed up the due diligence process while also giving sellers the opportunity to detect and address concerns that might cause a possible transaction to be delayed or terminated. As a result, sell-side QOEs may result in a better selling price and lower risk of post-closing litigation.

What is a quality of earnings report?

A QOE is an impartial review of a company’s historical financial records to create a realistic baseline of its present financial performance and decide whether the baseline level of profitability is sustainable in the future.

Unlike an audit, which confirms and authenticates a company’s financial status and performance, a QOE restates it by adjusting for one-time occurrences and extraordinary revenues or expenditure. A QOE looks beyond the numbers in financial statements to get a deeper understanding of a company’s long-term and forward-looking performance. It detects operational trends, anomalies, trouble areas, and other factors that may have an impact on the company’s current selling price and future profits predictions under new ownership.

In this regard, a QOE is comparable to a consumer engaging a professional mechanic to check and inspect a used car before purchasing it. The mechanic can advise the buyer whether there are any problems or hazards that may affect the car’s present value, the price they pay for it, and/or the number of years they can anticipate using and enjoying the vehicle without having to spend a lot of money on repairs and maintenance.

Lenders frequently ask buyers who are financing a transaction with debt to get an independent QOE to establish the target company’s track record of profitability and liquidity. In order to examine a firm and determine loan eligibility and terms, lenders often require at least three years of historical financial results.

Quality of Earnings Reports

What does a quality of earnings report cover?

A QOE assists in the understanding of a company’s performance statistics by industry, client, product line, or other pertinent business criteria.

While the technique and approach to a QOE report vary depending on the demands and goals of buyers and/or sellers, the evaluation always focuses on the factors that give the firm its worth. This can include, but is not limited to, a comprehensive analysis of current and forward-looking financial data, as well as the nature and quality of working capital and cash flow; unusual or nonrecurring items of revenue or expense; comparison of cash receipts and expenditures to reported figures; changes in accounting methods, rules, processes, or practices; analysis of business assets and inventories; reviews of related-party transactions and current contracts and conditions with customers and vendors; and possibly assessments of the company’s ownership and management structure. A QOE, goes further by normalising the target entity’s earnings before interest, taxes, depreciation, and amortisation (EBITDA), allowing for a more exact comparison of a company’s financial health to similar enterprises in similar industries and geographies.

In general, subtracting interest payments, taxes, depreciation, and amortisation from earnings eliminates many of the factors that might cause a company’s real performance to be distorted. EBITDA, on the other hand, focuses on income and expenditure connected to a company’s core activities, as well as its capacity to make money in the future. It aids in the removal of clutter that can have a one-time influence on a company’s real or normalised performance and cash flow, such as non-recurring transactions, and provides an apples-to-apples comparison of earnings for two or more companies.

Consider a family-owned business that pays excessive owner remuneration, as well as salary, incentives, and perks to its employees’ families. These charges will be recorded as business expenses on the financial accounts, reducing the company’s reportable profit. These costs, however, may not always transfer when a company is sold to a new owner. Instead, sellers can use a QOE report to recuperate those expenditures and add them back to income, boosting the earnings they disclose to prospective buyers.

Why would a seller need a quality of earnings study? QOE reports help buyers to ask the right questions, evaluate their risk exposure, and make better-informed judgments before concluding a purchase, making mergers and acquisitions more transparent. They are equally crucial for sellers who are preparing their firms for sale and want to optimize the worth of their company as well as the possible profit they may generate.

Business owners do not just employ corporate finance teams to sell their businesses and then sit back and wait for bids to come in. Instead, sellers must undertake their own due diligence, creating financial statements and supporting paperwork to ensure that claimed income and costs are accurate. Deals frequently break apart when a prospective buyer discovers facts that contradict or refute information given by the seller.

Business meetingA sell-side QOE helps to avoid this scenario by allowing sellers to objectively analyse their enterprises from the perspective of potential purchasers and uncover flaws before putting their companies on the market. Furthermore, they provide sellers with the opportunity to make modifications and address concerns so that they may show their companies in the best possible light to potential purchasers and have greater control over the whole sales process.

How do I get a QOE and how much does it cost?

Experienced, third-party accountants undertake QOE studies because they have the knowledge and skill to objectively examine all of a business’s operational and financial characteristics and comprehend how they form a potential deal. It is vital to highlight that a QOE does not follow a pre-defined analytical and method template. Rather, the scope and expenses of a QOE will be determined by the specific characteristics of each deal.

Before an agreement can be reached and a transaction can close, business sales, purchases, mergers, and acquisitions need a large amount of preparation, due diligence, and meticulous attention to detail. Time is a crucial issue that might generate hazards and cause a contract to fall apart. Before preparing their businesses for sale, savvy business owners should use expert accounting firms to conduct QOE studies. Outsourcing this due diligence to competent accountants saves time and helps sellers to identify the operational and financial opportunities and challenges that purchasers will use to determine the business’ viability and the price they are prepared to pay.