At a Glance
Main Takeaway
In merger and acquisition (M&A) deals, there is potential for significant financial and legal risk. A critical factor to consider when preparing to sell or evaluate a target company is the quality of its earnings.
Quality of earnings analysis is a comprehensive assessment of a company’s financial performance. It involves examining the company’s revenue, expenses, cash flows, and other financial metrics to determine whether its earnings are consistent with its current operations and other prospects.
Next Step
Understanding the importance of quality of earnings analysis in M&A deals ensures business owners and CFOs can implement a successful mergers and acquisitions strategy. A thorough quality of earnings report helps professionals align M&A transactions with strategic objectives and maximize value for all parties.
What is a Quality of Earnings Report?
A Quality of Earnings report (QoE) is a comprehensive analysis of a company’s financial performance, focusing on its reported earnings’ sustainability, reliability, and accuracy. Certified Public Accountants (CPAs), banks, and private equity firms typically produce the report to help potential buyers assess a target company’s financial health and value.
The QoE report includes an examination of the target company’s revenue streams, expense management, working capital management, and other financial metrics to determine the accuracy of its financial statements. The analysis also investigates any unusual accounting practices outside of U.S. GAAP guidelines or discrepancies with the company’s financial reporting.
The report provides insights into a company’s past and future earnings potential, identifying any risks that may affect the target company’s financial performance.
EBITDA: An Essential Focus of QoE Analysis
An EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) analysis is a crucial component of a QoE report. It involves calculating the company’s EBITDA for a specific period, which is then analyzed to identify nonrecurring expenses, such as one-time charges or non-operating expenses, that may distort the company’s financial performance and valuation.
EBITDA analysis is vital in M&A transactions, as it helps potential buyers understand the underlying earnings of the target company. By isolating nonrecurring expenses, the EBITDA analysis provides a more accurate picture of the company’s operational earnings potential by focusing on core earnings.
This information is crucial for buyers to determine the target company’s value and negotiate favorable terms. A professional EBITDA analysis plays a critical role in a company’s QoE analysis and is often a key consideration in M&A due diligence.
Why Does a QoE Matter During an M&A Deal?
QoEs are essential for M&A deals and provide company owners and executives with critical information. Understanding the value of the bid at hand will help you make well-rounded, accurate decisions.
For instance, your firm is interested in acquiring a target that has recently reported an increase in earnings. A QoE analysis can help determine whether that growth is sustainable and not simply due to a one-time event or accounting error.
If the analysis reveals concerns about the earnings quality, you can adjust your offer price or negotiate more favorable terms to account for the additional risk. Alternatively, if the analysis indicates a strong earnings quality, you can move forward with greater confidence, especially if you must increase the offer price to secure the deal.
A QoE performed by a professional accounting firm provides an objective and unbiased analysis, giving you an understanding of the target company’s financials. It also helps you avoid potential legal or financial liabilities that could be overlooked by poor due diligence.
A professional QoE report from an accounting firm can also help buyers negotiate better deal terms, such as purchase price adjustment, by providing a more accurate valuation of the target.
Benefits of a QoE
The motives of QoE analysis in M&A transactions vary depending on whether the party involved is a buyer or seller. A QoE analysis gives buyers an accurate overview of a target company’s financial status, enabling them to make informed M&A-related decisions. For sellers, a QoE analysis can identify areas of concern that may impact the sale price, allowing them to address issues and increase the value of their company.
For Buyers
For buyers, a QoE provides numerous benefits to aid decision-making throughout the transaction process. A QoE report identifies or validates adjustments to EBITDA, reflecting normalized earnings and analyzing enterprise value before and after the transaction or nonrecurring items.
It also helps address accounting issues by analyzing the target company’s financial statements for compliance with U.S. GAAP and making any necessary adjustments accordingly.
By promoting an efficient transaction, a QoE report can anticipate many of the tough questions a buyer would ask, allowing them to progress through accounting due diligence more efficiently. A QoE report from an experienced independent accounting firm lends credibility to a target company’s financial statements, providing added confidence in their decision-making process.
For Sellers
For sellers, a sell-side quality of earning report can help control the sale process by initiating due diligence and positioning the company through the sale process. It establishes a working capital target based on the recent historical working capital required to operate the business, normalizing for nonrecurring expenses and other potential adjustments to production.
By taking the first step with a sell-side QoE, a seller can ensure that adjustments favorable to them are considered. The process also identifies issues that can be addressed before a buyer begins due diligence, which can increase a buyer’s confidence and trust in the seller’s accounting and reporting. A QoE report from an experienced independent accounting firm provides due diligence support to a seller when responding to buyers. This is especially true if the target company’s internal accounting and finance team does not have the experience or resources to respond to due diligence inquiries efficiently.
Ensure Accurate Accounting Records
At Windes, we offer a range of M&A strategies, including financial and tax due diligence, working capital analysis, and quality of earnings analysis.
Our team of experienced professionals will tailor our services to fit your specific needs, no matter the size or complexity of your business. We can assist you in negotiating, structuring, and completing your M&A transaction with the most favorable outcome. From the initial letter of intent to post-close follow-up, we are here for you every step of the way to ensure accounting records are complete and accurate.
Contact our M&A Team today to learn how we can help with your M&A needs.