Financial statements provide the data to support prices in mergers and acquisitions (M&As). But are those reported results reliable and sustainable? After all, the value of a business is based on expected future earnings, not historical results. A quality of earnings (QoE) report prepared by a qualified business valuation professional provides critical insight into earnings, supports informed pricing decisions and facilitates due diligence.
As the name suggests, a QoE report evaluates the details underlying a company's earnings. For instance, gross profit (revenue cost of sales) may be broken down by geographic region, salesperson or product line to understand what's making money — and what's not.
Another important metric that valuators may address in a QoE report is earnings before interest, taxes, depreciation and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a company's ability to generate cash flow than net income does. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies and other strategic decisions that may vary depending on who's managing the company.
EBITDA isn't audited — and it can mean different things to different people. So, a QoE report typically "normalizes" EBITDA by:
Additional adjustments may be needed to reflect industry accounting conventions. One example is valuing the company's inventory using the first-in, first-out (FIFO) method rather than the last-in, first-out (LIFO) method. Another is recognizing revenue under the percentage-of-completion method rather than the completed-contract method.
It's also important to recognize that depreciation and amortization may not approximate the amount that the company would need to spend on long-term assets. This is especially true for companies that take advantage of 100% first-year depreciation tax breaks.
A QoE report may identify factors that affect the company's continued viability as a going concern, such as operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality and supply chain stability. In addition, a QoE report typically includes ratio analysis to identify trends and determine possible causes.
For example, suppose a company's inventory has increased substantially over the last three years. The increase might be expected if the company is growing. Or it might be a sign of poor inventory management practices or obsolete inventory. The days-in-inventory ratio (average inventory ÷ cost of sales × 365 days) can help identify what's happening.
When conducting M&A due diligence, QoE reports are essential for both buyers and sellers and can be customized to fit the user's needs. A sell-side QoE report can help establish a realistic asking price and attract prospective buyers. Sellers who obtain these reports before going to market also receive advanced notice of potential due diligence issues, giving them time to take corrective action or position their results in a positive light during letter-of-intent discussions. This helps minimize surprises, pricing adjustments and tensions during M&A negotiations. It also reduces the risk of post-closing disputes.
After signing a nondisclosure agreement, the buyer usually obtains a separate QoE report to assess the sustainability of the target company's earnings. This helps identify risks and reporting errors, align the parties' expectations, and prevent costly post-deal surprises that could lead to impairment charges down the road.
Whether you're preparing a business for sale or evaluating an acquisition opportunity, engage an experienced business valuator to prepare a QoE report early in the transaction process. These professionals understand how to bridge the gap between reported results and current market value, providing objective insights you can rely on. We can deliver tailored QoE analyses that fit your needs. Contact us to learn more.
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