Are you thinking about merging with or acquiring a business? CPA-prepared financial statements can provide valuable insight into historical financial results. But an independent quality of earnings (QOE) report can be another valuable tool in the due diligence process. It looks beyond the quantitative information provided by the seller’s financial statements.
These reports can help buyers who want more detailed information — and help justify a discounted offer price for acquisition targets that face excessive threats and risks. Conversely, when these reports are included in the offer package, it can add credibility to the seller’s historical and prospective financial statements. They may also help justify a premium asking price for businesses that are positioned to leverage emerging opportunities and key strengths.
QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. Rather than focus on historical results and compliance with U.S. Generally Accepted Accounting Principles (GAAP), QOE reports focus on how much cash flow the company is likely to generate for investors in the future.
Examples of issues that a QOE report might uncover:
- Deficient accounting policies and procedures,
- Excessive concentration of revenue with one customer,
- Transactions with undisclosed related parties,
- Inaccurate period-end adjustments,
- Unusual revenue or expense items,
- Insufficient loss reserves,
- Insufficient cash flow from operations and/or lack of liquidity from financial sources
- Idle equipment and facilities or insufficient resources for growth projections
- Overly optimistic prospective financial statements.
A QOE report typically analyzes the individual components of earnings (that is, revenue and expenses) on a month-to-month basis. This helps determine whether earnings are sustainable. It also can identify potential risks and opportunities, both internal and external, that could affect the company’s ability to operate as a going concern.
EBITDA vs. QOE
It’s common in M&A due diligence for buyers to focus on earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months. Though EBITDA is often a good starting point for assessing earnings quality, it may need to be adjusted for such items as nonrecurring items, above- or below-market owners’ compensation, discretionary expenses, and differences in accounting methods used by the company compared to industry peers.
In addition, QOE reports usually entail detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.
For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue should be analyzed to determine if the new business is profitable — or if the revenue growth results from aggressive price cuts or a temporary change in market conditions. If the latter, additional focus may be required to evaluate customer payment trends and viability
Fortunately, the scope and format of QOE reports can be customized, because they’re not bound by prescriptive guidance. The best such reports, whether prepared for a buyer or seller, focus on core issues of interest and avoid including generic and /or filler information. Contact us for more information about how you can use an independent QOE report in the M&A process.