A Quality of Earnings (QoE) report examines a company’s historical financial statements to detail the accuracy and sustainability of a company's cash flows. It aims to provide a comprehensive understanding of the underlying factors driving a company's financial performance beyond a surface-level financial statement analysis. A third party typically performs a QoE analysis. It includes agreed-upon due diligence procedures tailored to the needs of the business or potential transaction to assess the financial information available most effectively.

Purpose of a QoE Report

A QoE analysis extends beyond financial evaluation; it serves as a compass for informed decision-making across various business scenarios. It supports buy-side and sell-side transactions, ultimately enabling more accurate valuations and a smoother due diligence and negotiation process. It plays a crucial role in assessing investment opportunities through targeted due diligence procedures that help stakeholders evaluate potential risks and uncertainties in a company's financial performance.

Furthermore, a QoE analysis can aid in assessing internal transaction readiness, ensuring companies are well-prepared for significant events such as a company sale or any significant internal strategic initiatives. It provides insights into the strength and consistency of earnings, and the overall quality of a company’s financial information, enabling stakeholders to make more informed decisions.

Components of a QoE Report

Five common elements of a Quality of Earnings report include:

1. Historical Financial Statement Analysis

A QoE analysis includes a historical financial statement analysis to evaluate trends, identify fluctuations, and further assess the reliability of reported earnings. The analysis provides a comprehensive overview of a company's financial position over the agreed-upon historical period (typically over two-three years).

2. EBITDA Adjustments

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) adjustments eliminate non-operating and non-recurring income/expenses to normalize a company’s earnings. Adjusted EBITDA provides a clearer view of a company's true operating performance, enabling QoE report users to assess the company's profitability and reliability of cash flows. Adjusting for one-time expenses and non-operating income normalizes a company’s year-over-year EBITDA to provide a more accurate representation of a company’s ongoing core earnings.

3. Pro Forma Adjustments

Pro Forma adjustments help stakeholders assess future earnings and cash flows of the business based on future assumptions or expected changes to the business (I.e., rent, personnel changes, employee benefits, etc.)

4. Proof of Cash

A proof of cash reconciles reported net revenues and expenses to cash inflows and outflows per supporting documentation like bank statements. It is especially important when a company does not have compiled, reviewed, or audited financials available. A proof of cash utilizes third-party source documents (I.e., bank statements) to provide QoE users an independent look at the reliability of a company’s reported cash flows.

5. Working Capital Analysis

QoE’s typically include a calculation of a net working capital target to assist both buyers and sellers in the working capital target negotiation process.

Common Red Flags Identified in a QoE Analysis

A Quality of Earnings analysis includes targeted due diligence procedures to aid in identifying common red flags, including:

1. Financial Reporting Issues

• Non-compliance with Generally Accepted Accounting Principles (GAAP)
• Improper revenue and expense recognition practices

2. Unreasonable EBITDA Adjustments

• Adjustments that may be overstated
• Assess the reasonableness of management-provided adjustments

3. Unusual or Excessive Non-Operating Items

• Identifies any non-operating or personal income and expenses that should be adjusted for
• Assesses the impact of one-time, non-recurring income and expenses that should be adjusted for

4. Inconsistencies between Reported Earnings and Cash Flows

• Identifies any variances that raise concerns about the accuracy of reported cash flows

5. Unreasonable/Unnegotiated Working Capital Targets

• Assesses the fairness and achievability of working capital targets set in buy-side or sell-side transactions
• Evaluates if the net working capital target aligns with industry norms and any specific characteristics of the business

Importance of Professional Assistance

Engaging professionals with significant transaction advisory experience is crucial to ensure a comprehensive and objective evaluation of a company's Quality of Earnings. Our team of experts leverages their industry knowledge and expertise to tailor each QoE analysis to a target company’s significant areas of risk. By seeking professional assistance, business owners and investment professionals can leverage a QoE analysis and report to assess a company’s quality of financial information (without getting a formalized audit, review, or compilation) to ultimately identify any significant areas of concern.

Lutz M&A offers Quality of Earnings reports tailored to your specific business or transaction needs in addition to a wide range of transaction advisory service offerings. Please contact us for more information.