You are a business owner and have exhausted all the available tools to organically grow your business and are ready to explore growing through acquisition. While you may be comfortable operating your existing business, you may have some hesitation when it comes to the process of acquiring another company. We know, you cannot afford to execute a bad acquisition! Performing financial due diligence on the target, once located, is not uncommon, but the term Quality of Earnings (QoE) just might be. This article is designed to explain QoE reports and how they can serve as a beneficial tool throughout the acquisition process.
Financial due diligence and QoE are used interchangeably in the M&A world and essentially mean the same thing. There is, however, a distinction between a QoE and a business valuation.
What is a Quality of Earnings Report?
A QoE is a review of historical numbers and a business valuation is a process of discounting projected future cash flows using certain assumptions to assign a value. The purpose of a QoE is to measure a company’s ability (on a quantitative and qualitative basis) to be profitable at its core business by reviewing historical numbers.
From a quantitative basis, the report details in dollars and cents how much the company is making at its core business. That number is defined as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The qualitative aspect describes the risk factors associated with those earnings. The report allows you to go into the deal with your eyes wide open as to how the business is performing at its risk factors. There are three steps in producing a QoE report.
Step 1: Get to GAAP
Most small businesses utilize a cash basis or modified cash basis of accounting. Bankers and investors require financial statements to be reported using Generally Accepted Accounting Principles (GAAP). GAAP sets the standard on how business activities are to be measured from an accounting standpoint and allows for a much clearer understanding of the assets and liabilities of the business and how the business is performing on a month over month and year over year basis.
The objective of GAAP is to get all business activities in the correct month and match expenses to revenue. The major adjustments from cash or modified cash to get to GAAP include:
- Proper revenue recognition
- Capitalizing inventory
- Recording prepaid expenses
- Recording accrued liabilities
- Recording allowances.
The end result of converting to GAAP is the balance sheet accurately reflects the proper value of the assets and liabilities of the company at any given point in time and the Income Statement accurately matches the expenses to the revenue and accurately reflects when the revenue was earned. Including in this step is verifying that the detailed subledger reports match the financial statements and that the bank statements reconcile to the financial statements.
Step 2: Remove Non-Recurring Income and Expenses
Step 2 of producing a QoE is to remove all non-recurring revenue and expenses so you are left with core business activities.
Examples of non-recurring income activities include PPP loan forgiveness, Employee Retention Credits (ERC), Economic Injury Disaster Loan (EIDL) forgiveness, bank debt forgiveness, gain on sale of assets, litigation awards, insurance claim awards, workers’ compensation refunds or unusual one-time revenue projects.
Examples of non-recurring expenses are family members on the payroll that do not perform any duties, owner personal expenses run through the business, expenses associated with non-recurring revenue, litigation fees, litigation losses, loss on sale of assets, loss on discontinued operations, or loss due to a natural disaster.
Again, the objective of a QoE is to understand how the core business is performing and removing/adjusting non-recurring income and expenses is a critical step in the process.
Step 3: Analyze the Core
Step 3 is what separates the great QoE service providers from the good. It is the deep dive analysis where you learn the true strengths and weaknesses of the business and can make an even more informed decision about the strength of the business.
The deep dive includes an analysis of the customer concentration, vendor concentration, employee turnover, age of the workforce, key employees, employee compensation, age of equipment and potential Capex needs, inventory turnover, profit margin by customer/product/service, and monthly/yearly trend analysis. This type of deep dive analysis can bring to light critical issues of the business that would not be known with a cursory review of the financials.
The QoE report will provide thorough commentary on each of the findings uncovered in the analysis. A bad QoE is similar to a controller closing the books each month and handing the financials to you with no commentary even though there are wild swings in the performance of the company each month. A good QoE is similar to a CFO meeting with you for 3 hours and explaining the key drivers of the business, what is going on in the industry and what specific action steps need to be taken to improve the value of the company.
Quality of Earnings Report Benefits
There are several benefits to purchasing QoE services. 1) The financial statements are now in GAAP form which can be shared with investors or the bank to secure financing. 2) The NWC components become easier to understand, value, negotiate, and mitigate post-close disputes for both parties once GAAP is adopted for the calculation. 3) You have a roadmap of the accounting policies and procedures that need to be fixed post-close. 4) You have a roadmap on what needs to be improved operationally post-close to increase the profitability of the business. 5) You increase your leverage in renegotiating the deal because you now know more about the strength and weaknesses of the target than the current owner.
Costs and Timing
Cost and timing are dependent on several variables. Those variables include 1) the ability to get access to the target’s accounting software and pull/convert reports to Excel, 2) the availability of owners to answer questions, 3) how close the target follows GAAP, 4) complexity of business 5) carries inventory and 6) the number of entities involved. Fees are billed by the hour but an estimate is typically provided. For example, an estimate for a single entity doing $20mil in sales that carries inventory, has a copy of QuickBooks provided, follows modified cash accounting, houses average internal accounting team talent, has a responsive owner, and requires no PowerPoint, would cost around $40k and take about 3-4 weeks to complete.
Finished Product
The finished product is an Excel Data Book with about 40 tabs walking from the raw financials provided all the way through to the adjusted EBITDA for each of the months being analyzed. Each EBITDA adjustment has its own tab indicating the value of the adjustment by month and explaining why the adjustment is being made. There are tabs reconciling the bank statements to the financial statements and tabs tying out balance sheet accounts to the detailed supporting documents. Each analysis component of a deep dive analysis will have its own tab explaining the findings. For an additional fee, the Excel Data Book can be converted to a PowerPoint presentation.
How to Select a QoE Provider
Just like any other major decision, it is important to select an expert. Select a firm that has a dedicated department that focuses solely on QoE services. It is also advantageous to work with professionals that have deal experience. A QoE has the ability to blow a deal up and it is nice to work with someone who knows how to put it back together again while maintaining the relationship between all parties involved. Time kills deals so it is important to pick a provider that has the capacity to move at the pace needed and at a price you can afford.
To further discuss this information in more detail, or to explore additional business strategies, contact Transaction Advisory Services Senior Director Wade Kozich.
Article written by:
Tim Moellering, CPA
Director, Transaction Advisory Services
