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Quality of Earnings: Understanding an Essential Piece of the M&A Puzzle
The ultimate success of an M&A transaction depends on a lot more than a firm handshake, no matter how firm that handshake might be. In other words, both buyers and sellers need to be meticulous, leaving no due diligence stone unturned or anything to chance.
That's what makes the Quality of Earnings (QofE) report such an important piece of the complex M&A puzzle – it provides a clear picture of operations that sellers can leverage and buyers can depend on for accuracy. So on that note, let’s take a closer look at this critical analysis, sharing insights and best practices we use in our Transaction Advisory practice along the way.
What Is the Quality of Earnings (QofE)?
You'd think we're starting off with an easy, high-level softball, but that's not really the case. And it doesn't have much to do with the QofE itself but what people really mean when they say quality of earnings.
You see, quality of earnings can have different meanings. In the big world of mergers and acquisitions, the term has basically become synonymous with what those in the transaction advisory space call a financial due diligence (FDD) report.
In fact, we've spoken at length in the past on both sell-side and buy-side financial due diligence reports – along with handy checklists for each. And if you were to check out either of those two links right now, you’d see that a Quality of Earnings analysis is a component of each.
Therefore, just to keep everything straight, when we refer to the QofE, we mean the analysis that's part of a more comprehensive financial due diligence report. So what is a QofE analysis all about, then, you ask?
Well, the QofE is often the beating heart of that larger, high-quality financial due diligence report, providing a clearer view of a company's ability to generate future cash flows based on past results. A buyer typically uses the QofE analysis as a pricing baseline, the starting point to determine how much they’re willing to pay for a target company.
Put another way, as you can see in our handy Quality of Earnings template, the QofE analysis walks the reader from reported EBITDA – earnings before interest, taxes, depreciation, and amortization – to adjusted EBITDA, taking out or adding back one-time items, nonrecurring items, or changes in the company's operating profile. This approach standardizes earnings by whittling away those items that skew an accurate view of cash flow under normal operating conditions.
As you might guess, these adjustments come in all shapes and sizes, usually falling under the management, due diligence, or pro forma adjustment categories. And although a list of sources for QofE adjustments can go on for pages, the more common ones include:
- Audit workpapers
- Confidential information memorandum (CIM)
- Management's proposed EBITDA adjustments
- Discussions with management
- Fluctuation analysis, year-over-year and/or monthly
- Review of general ledger account detail
The point is, adjustments aren't uniform or consistent from transaction to transaction. Therefore, when we’re preparing a QofE analysis, we include a detailed discussion of each QofE adjustment, outlining our reasoning behind it, what it’s impacting – especially net working capital (NWC) – and substantiating the adjustment with supporting documentation. And, again, we continue that same process for every QofE adjustment.
Financial Due Diligence (QofE) vs. an Audit
From a boots-on-the-ground perspective, one of the more common issues we run into is the misconception that a QofE report – a financial due diligence report in Embark-speak – and an audit can serve the same function. In reality, though, these are two very different things.
Remember, the whole point of a financial due diligence report is to normalize and showcase operating cash flows, cutting the proverbial fat from a company's financial statements. Thus, an FDD report gives a potential buyer a truer measure of normal operating conditions and financial performance. As such, an FDD report doesn't have an absolutely defined form or level of materiality.
Conversely, an audit is typically balance sheet-focused and follows strict GAAS guidelines. Also, audited financial statements fall in lockstep with GAAP, unlike the EBITDA adjustments so central to a QofE analysis and a financial due diligence report.
Simply put, an FDD report provides insights and perspectives that audited financials typically lack. Therefore, within the specific context of an M&A transaction, an FDD report serves as a window that a buyer needs to make an informed investment decision. Ultimately, it's an apples or oranges scenario, where FDD reports and audits each have their own specific roles.
The Benefits of Quality of Earnings for Sellers and Buyers
Naturally, sellers and buyers derive different benefits from the Quality of Earnings. Yet both the analysis and financial due diligence report can be crucial for both parties, just from opposite ends of the M&A spectrum.
QofE Benefits for Sellers
For sellers, the QofE is an opportunity to get any pesky skeletons out of the closet and truly understand what's happening under the hood of the business.
When we're working with sell-side clients, drilling down to those adjusted earnings figures allows us to present them to potential buyers in the most favorable yet accurate and objective light. This way, we can get ahead of any issues rather than being blindsided down the road. Because once you pass the point of no return, the only alternatives are to step away from the transaction or accept a lower purchase price. And neither of those is a great option for a seller.
QofE Benefits for Buyers
On the buy-side, the quality of earnings allows you, the potential buyer, to kick the financial and operational tires, ensure there aren't any inflated earnings and wonky accounting policies lurking around the corner, and fully understand what's happening with the business.
Further, since other stakeholders also need assurance that everything is on the up and up with a target company, the Quality of Earnings analysis and larger FDD reports are also critical for lenders, private equity investment committees, insurance companies, and other key related parties. When an unbiased, professional team like Embark's Transaction Advisory practice is involved, that expert outside opinion usually has an awful lot of credibility.
Also, within the context of a comprehensive FDD report, the QofE analysis is usually accompanied by analyses surrounding net working capital (NWC), debt and debt-like items, and other ancillary analyses like a cash proof of revenue. All told, these insights help support a company's earnings, backstop a seller's claims, and provide peace of mind for buyers and interested stakeholders.
The Role of Management in the Quality of Earnings
Finally, because effective financial due diligence takes a village, management can play an important role in making the entire due diligence process as smooth, efficient, and productive as possible. Depending on the nature and size of the company, the CFO, controller, and owner are often the ones providing the accounting and finance information to the group preparing the FDD report, not to mention any background insights on the company and trends in the reported financials.
Of course, we've only touched on the most critical aspects of the QofE in these musings. For a more in-depth look at how it fits into the bigger financial due diligence picture, we encourage you to look at our sell-side and buy-side due diligence reports and checklists.
Also, it goes without saying that, whether you're a buyer, seller, or involved third-party, our Transaction Advisory team is always ready to help your M&A transaction be as successful as possible. It's what we do.