Quality of Earnings Report: The Secret Weapon Buyers Won’t Tell Owners About

February 28, 2024
Quality of Earnings Report: The Secret Weapon Buyers Won’t Tell Owners About

Are you planning to sell your company in the next year or two? 

If so, think about commissioning your own Quality of Earnings report — BEFORE you go to market. Why? Because your buyer will commission one. And it could mean you’ll be leaving money on the table.

A QOE is the business valuation standard prospective buyers use to determine a final purchase price for target companies. If you haven’t commissioned your own, you’ll by necessity be relying on the one your acquirer commissions.

As InterimExecs CEO Robert Jordan said in a recent webinar (scroll down to watch the 8-minute video), consider a middle market business owner who has signed a letter of intent agreeing to sell the company to a private equity fund for 10 times earnings. He believes EBITDA to be $10 million and expects to close for $100 million.

Then the acquirer commissions a QOE to ensure this is a solid investment decision. The report comes back with an adjusted EBITDA of $9.5 million. BAM! The closing price just dropped by $5 million.

What is a Quality of Earnings Report?

A key part of the due diligence process in an acquisition, a quality of earnings report, is a deep dive into a company’s financial statements and operations. It goes beyond just the company’s earnings history and aims to assess the sustainability, accuracy, and potential for future earnings.

During a Quality of Earnings analysis, an independent accounting firm looks at:

  • Financial performance A close examination of the company’s financial information, including income statements, bank statements, balance sheets, tax returns, and cash flow statements to identify any inconsistencies or unusual items.
  • Revenue and expenses: A deep dive into recurring vs. non-recurring items and cash vs. non-cash transactions.
  • Management practices: An assessment of the accounting policies, internal controls, and overall management practices that influence financial reporting.
  • Operational factors: An understanding of the underlying business operations, industry trends, and competitive landscape that impact future earnings potential.
  • Working capital: A look at current assets and liabilities including inventory turnover, days sales outstanding, and days payable outstanding to assess how efficiently the company converts its resources into cash.
  • Red flags: An analysis of areas of concern such as slow inventory turnover, liquidity concerns, or insufficient accounting standards that can affect enterprise value.

Who Should Commission the QOE?

Make no mistake: If you are hoping for a big payout in a sale to a PE fund, the buy-side WILL commission its own QOE.

But, Jordan says that, while QOE consulting services can be expensive, the sell-side company should do its own before going to market, for three reasons:

  1. Commissioning your own QOE allows you to set the parameters the outside CPA will use to investigate everything from receivables to net working capital.
  2. Potential buyers will be favorably impressed at such a high level of financial sophistication.
  3. You’ll have the tools you need to go into battle fully armed — including the ability to counter any red flags that might arise.

What You Need to Know About Commissioning a Quality of Earnings Report

This is a sophisticated analysis of your company’s finances and operations. While your stakeholders — shareholders, board members, the management team — believe that your internal financial health is good, your firm abides by Generally Accepted Accounting Principles, and you make an attractive target for an acquirer, conducting QOE analysis is a unique financial investigation.

And, because it is so critical to the price you’ll get when you sell, commissioning a QOE report requires unique financial skills.

Bringing in an interim or fractional Chief Financial Officer who has overseen the process 10 or 20 or more times for other firms is your best bet for framing the scope of work correctly, answering critical questions during the process, and delivering the best possible outcome.

Some points to consider:

  1. Is your financial house in order?
  2. What will the highest bidder find when the Quality of Earnings report is complete?
  3. Is your team battle-ready for the sale process – the entire team aligned, firing on all cylinders in operations, technology, marketing?
  4. Could outside resources enhance your position?
  5. Are your earnings as robust as you’d like?

The bottom line: There are people who have done this before and they can help you do it now. 

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InterimExecs RED Team is an elite group of CEOs, CFOs, COOs, and CIOs who help organizations through turnaround, growth (merger, acquisitions, ERP/CRM implementation, process improvement), or absence of leadership. Learn more about InterimExecs RED Team at www.interimexecs.com/red-team or call +1 (847) 849-2800.

More Resources:
*Preparing Your Company for a Sale and How to Get the Help You Need
*Business Exit Strategy Guide for Owners