Quality of Earnings Reports Impact Valuation

How Quality of Earnings Reports Impact Valuation

Securing a Quality of Earnings (QoE) report is often a routine step in the due diligence process for acquisitions. EBITDA is not a complete indication of financial performance for a business. A quality of earnings report assesses other factors that impact the ongoing viability of company earnings. Buyers use them to validate what they are buying and potentially to renegotiate the purchase price and terms of the deal. Some sellers proactively seek a report well in advance of planned transactions to give themselves a chance to prepare for concerns that may arise, eliminate surprises, and/or correct factors that may detract from valuation in a future transaction.

It’s important to differentiate between having audited financial statements and a QoE report, as these are quite different reports. Both give insights into a company’s finances, but they serve different purposes and provide different perspectives.

• An audit opines on the accuracy of a historical period. An audit looks backwards, giving an opinion on the financial statements and health of the company. It is valuable to a buyer or investor to have the confidence of an audit report.
• A QoE report assesses business risk and predictability of earnings. The QoE looks at the sustainability and accuracy of future profits. It entails a deep dive into many facets of operations including the status of contracts, customer concentration risk, the ability to deliver services, and other expense drivers. Market trends and regulatory changes are additional areas of focus. A QoE goes well beyond the scope of an audit.

The Role of EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a key metric used in QOE reports and commonly in the development of a purchase or investment price.

EBITDA provides insight into possible future earnings without the burden of the current company’s capital structure or debt levels. This enables a buyer to project what their own capital structure superimposed with the target’s EBITDA is capable of delivering post transaction.

The Value of Operational Experience in Preparing a QoE

Operational experience can be a significant help and differentiator in the preparation of a QoE report. As previously mentioned, the explanations to questions that arise in the preparation of a QoE are very impactful to the interpretation of earnings and the ultimate opinion of the report which in turn impacts the price a buyer is willing to pay.

Operationally experienced professionals are well-versed in navigating company-specific matters that often hide behind raw numbers on paper. Explaining these nuances clearly can mean a significant difference in transaction pricing. Careful attention to unique operational elements and ensuring they are very clearly explained often works in the favor of the seller. A recent example of this occurred when a vcfo client was recording a substantial recurring quarterly fee with a major client (beyond the ongoing purchases of the client). The fee documentation was not clear that the fee occurred every quarter. The Buyer prepared QOE discounted this fee based on the documentation.  Vcfo looked deeper and was able to help the Buyer explain the transaction more fully and include the fee as recurring revenue and therefore in the base upon which valuation was calculated.  This one worked in favor of the Buyer.  It can work the other way too when operational experience recognizes something not obvious in the numbers.

Common Challenges in Quality of Earnings Reports

Challenges in supporting earnings often emerge as revenue complications, working capital calculations, or client concentration issues.

• Many companies record revenue on a cash basis, which can have a significant impact on earnings when converted to accrual basis.
• Seasonality in revenue can be challenging if not accounted for and explained properly in the report.
• Working capital (current assets less current liabilities), an indicator for short-term liquidity, presents challenges due to varying definitions and methods used across industries and firms. Determining normalized levels requires careful attention to eliminate confusion or misunderstandings.
• Great clients are a real positive for a business until they represent too large a proportion of total revenue. Anticipate questions in this area, and to the extent possible, work to reduce the risk to the company that your largest client or small set of clients can have on future revenue for the company.

When Should a Company Have a QoE Prepared?

Some companies wait for the buyer to require one or perform one. Other companies take a proactive approach to control the process and know the information in advance. A properly prepared QoE report provides clarity about the accuracy, quality, and sustainability of the company’s earnings, eliminates surprises, and significantly improves the seller’s position during the negotiation process. This can result in a higher selling price during negotiations.

The ideal window tends to be within six months before a sale. QoE reports can generally be easily updated if a transaction is delayed.

How Long Does it Take?

This depends on:

• The size and complexity of your organization,
• The nature and volume of transactions, and
• Whether any unusual activities need detailed examination.

Generally, it takes around four weeks from kickoff until completion, although more complex businesses might take longer.

Summary

Sellers will often encounter the need for a QoE report during the buyer’s due diligence process. If not required by the buyer, the seller may want one to proactively support their negotiation position.

• Our practice has not experienced a situation where a seller was not able to negotiate favorably for more than the cost of the QoE report they initiated.
• Remember, QoE is not the same as an audit, though both are important for significantly different reasons.
• Ordering the report as the seller puts you in charge of timing, pricing, and preparer.
• Consider the value of operationally experienced support in the preparation of the report and through the selling process.
• Pay very careful attention to all questions received as the report is prepared.
• Make sure you understand why the question is being asked and that your answer is as detailed as necessary to convey the complete picture.
• Be sure to walk through the results of the report in detail with the preparer. You may notice an error that is negatively impacting the report and by extension the value.

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