What is a Quality of Earnings Report

So you are planning to exit your business and are ready to take it to the market. Your financial documents are in place and you don’t feel like any buyers would draw any of your expenses into question or find anything else that could go wrong to derail the deal. 

For some businesses, the quality of the earnings report (often referred to as a QoE or a QofE report) can be the missing piece. 

Potential buyers are interested in knowing whether your financial reports reflect the true state of your earnings, whether your earnings are kept on cash, modified cash, or accrual basis, recurring, re-occurring, or non-recurring, or if your earnings are sustainable the way that you project them to be. 

Therefore, there may be a need for an independent and objective assessment of your company’s earnings. This enables potential buyers to make a more informed decision. The quality of earnings report serves this purpose. 

This post discusses the meaning, importance, and elements of a quality of earnings report and why we at Raincatcher will occasionally encourage you to get a quality of earnings report done by a reputable accounting firm if we believe it will support a higher valuation for your business.

What is Meant by the Quality of Earnings Report?

A quality of earnings report summarizes the company’s revenue model, the reliability of its financial reports, adherence to standard accounting practices, any deviations from GAAP accounting, and the future projections of its earnings by delving into 3-5 years of historical financial and operational data

The quality of earnings report provides a detailed review of the economic reality of your company, which helps potential buyers such as private equity groups, family offices, or other sponsors have a greater level of clarity into the financial performance of your business.

A QoE evaluates the accuracy, sustainability, and transparency of your financial statements (which affects business valuation and growth prospects) while uncovering potential risks.

It also informs stakeholders (buyers, investors, and lenders) of the true financial performance, and how likely those earnings will continue. 

For instance, a QoE report may reveal bad accounting practices such as improper revenue recognition or problems with your revenue streams: a trend of falling sales, over-dependence on a single client, or a one-time large expense transaction skewing bottom line figures. 

Additionally, the quality of earnings report helps potential buyers get comfortable enough with the financial performance that they may be willing to submit an offer when they otherwise wouldn’t have, or make an offer at a higher price and more favorable terms than they would have without reviewing the QoE.

What Does a QoE Report Highlight?

A QoE report highlights several critical factors that reveal your firm’s financial performance, including: 

  • Normalized EBITDA – plus, add-backs and adjustments to arrive at the adjusted EBITDA. 
  • Consistency in financial performance by analyzing historical financial data. 
  • Any customer or supplier concentrations that business owners or investors may have concerns about.
  • Earnings and gross margin by divisions/products, customers, or geographies. 
  • Operating expenses. 
  • Key highlights P&L and balance sheet. 
  • Normalized working capital. 

Elements of Quality of Earnings Report

A quality of earnings report typically looks at three core areas: adjusted EBITDA, proof of cash, and working capital

Adjusted EBITDA: For middle market transactions, enterprise value is commonly calculated by applying a valuation multiple to a company’s EBITDA (earnings before interest, taxes, depreciation, and amortization)  which is a financial metric that clearly shows a company’s profitability and operating performance.

During the quality of earning analysis, critical adjustments (non-recurring expenses, management replacement expenses, and other pro forma adjustments) are factored into the reported EBITDA by taking a deep dive into the P&L and balance sheet. 

Adjusted EBITDA is a crucial aspect of the quality of earnings analysis and the overall due evaluation process – it normalizes financial statements and provides insights into the go-forward profitability of the company. 

Proof of cash: In quality of earnings analysis, cashflows recorded in bank statements are compared to the revenue and expenses reported in the company’s financial statements to reflect the accuracy of a company’s cash position, cash flow trends, vash cycle, and cash performance. 

Working capital: Potential buyers are interested in knowing the ability of your business to manage current assets, liabilities, and cash flows. Negative working capital can trigger liquidity and financial management concerns for potential buyers.

Therefore, the quality of earnings analysis offers potential buyers a clear picture of the working capital position and its financial implications on the overall deal.

Most transactions include normalized working capital (typically seen as the average level of short-term assets and short-term liabilities) which acts as an indicator of your business’s operational efficiency and financial stability. 

Why is the Quality of Earnings Report Important?

The quality of the earnings report is important because it’s a crucial part of due diligence. It instills confidence in potential buyers investors and lenders by showing the inner workings of your business and its financial performance. 

It shows exactly how your business gets paid, by whom, and when, how accurately your financial documents report it, what the nature of your expenses are, and therefore, how sustainable your earnings are. It serves several key purposes during due diligence: 

  • Establishes reliability, transparency, and efficiency: A sell-side QoE helps assure potential buyers that your earning reports are reliable, transparent, and efficient. Buyers are more likely to bid higher and close the deal faster while buying businesses that look clean. 
  • Offers a better picture of enterprise value: QoE helps identify or validate EBITDA adjustments to reflect normalized earnings and provides a clearer picture of enterprise value.
  • Quickens due diligence: A sell-side quality earnings report offers another layer of credibility to your business and its financial statements. This will help you sail through the due diligence process by offering a more transparent view of the financial health of your business. 
  • Maximizes deal value: It can help you maximize the deal value by not only substantiating your earnings but also identifying all potential add-backs to adjusted EBITDA.
  • Helps identify accounting issues: QoE also helps in unearthing potential accounting issues by ensuring that they comply with the generally accepted accounting principles in the United States (“US GAAP”) or outlining any areas where the books differ from GAAP practices. 
  • Helps lenders assess creditworthiness: A clean QoE report helps potential buyers get the deal financed by proving the company’s profitability and ability to service their debt. This may also help buyers get more favorable lending terms and therefore be able to pay a higher price for the company.

What is the Difference between Audit and QoE?

The difference between an audit and a QoE is that while an audit helps assure buyers regarding your financial reporting practices, QoE offers a more comprehensive view of your company’s earnings and financial health. 

The audit is focused on accounting and it analyzes whether your historical financial reports comply with generally accepted accounting principles. Therefore, an audit is backward-looking.  

In comparison, QoE is forward-looking and focused on the economic earnings of your business both on a historical basis and a normalized, go-forward basis. It delves deeper than the surface of your report financial statements and determines the strength and consistency of your revenue flow. 

While audited reports help you prepare for selling your business, a QoE report supplements your reports by providing another layer of credibility regarding your firm’s financial health. 

How to Get a Quality of Earnings Report?

If you are entertaining the idea of selling your business, getting a quality of earnings report can be an important due diligence step you can undertake. However, remember that QoE may or may not be necessary for all businesses. 

An M&A advisor like Raincatcher can help you determine whether it’s a worthwhile investment for your business. 

Since the QoE report is developed by an independent third party, getting in touch with an experienced business broker or M&A advisor is a great starting point. The right business broker/M&A advisor has the critical resources like competent accountants and financial experts to arrive at a comprehensive QoE report. 

Raincatcher’s team of M&A experts can guide you on this to ensure you achieve a successful outcome while selling your business. Get in touch with us today to explore how together we can unlock the full potential of your business.