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Quality of Earnings Template & Best Practices Needed For M&As & Other Transactions

When a transaction is on the horizon, you have to be on your A-game. No matter if it's a merger, acquisition, or straightforward investment, it's time to put your best foot forward, shine your company's metaphorical shoes, and give that external party an accurate but compelling reason to proceed with the transaction.

That's where a quality of earnings report (QOE) comes into play. With many details not outlined in the income statement, the QOE takes a deeper, more revealing dive into your sources of cash. In short, it trims the proverbial fat from other reports to provide outsiders a clearer picture of your operations and financial stability. However, because a QOE is likely outside of your accounting team's everyday tasks, there can be a certain degree of confusion and hesitancy over its preparation and purpose.

Embark understands both the importance of a QOE as well as the need for some guidance and direction. Therefore, since we firmly believe that sharing our knowledge rather than hoarding it like Pokémon cards is in everyone's best interests, we're providing our insights into the QOE along with a handy template to get you started. Sure, every company is at least a little different, including yours, but between the following nuggets of informative goodness and our basic but insightful template, you're well on your way to completing a successful transaction.

Download: Quality of earnings template

The Essence of Your Financial Health

One of the central concepts of a QOE is to eliminate any skewed perspectives resulting from non-recurring items or extraordinary events that are not a part of your normal operations. Whether that's a big ol’ golden parachute check you wrote last year or a smaller than usual expense, the QOE takes those items out of the loop to presents a normalized snapshot of your company’s performance and cash flow.

As you'll see from our accompanying template, a properly constructed QOE doesn't try to hide these types of line items but, instead, removes them from the picture while also justifying their exclusion. Although the income statement is the principal focus of the report, a QOE also provides details into other financial statements and facets of operations as well.

Sometimes that means providing a closer look at the condition and value of different assets on your balance sheet, other times it's your controls, key clients, products, or anything else pertinent to the outside party. Likewise, providing an adjusted EBITDA figure gives your suitor a better idea of what your typical margins look like without those pesky non-recurring items and one-off events. In other words, you’re prettying yourself up in a QOE without conveying a false or even exaggerated image.

Quality of Earning Best Practices

First and foremost, remember that either selling your company or attracting investment capital can be stressful enough as it is without placing undue and unfamiliar responsibilities on your team. For many firms, a QOE, as simple as it might seem at first glance, is one of those responsibilities. This is an instance where you need to get things right the first time so, if bringing in outside help is warranted, then so be it. Granted, Embark just happens to have that particular expertise and is only a phone call away, but the overriding point is to not burden your team of well-meaning accountants with something that’s so important but outside of their purview. There, we said it. Now back to the good stuff.

Start with a Good Foundation

No matter how complex your operations might be, creating an accurate and impactful QOE doesn't require you to reinvent the financial reporting wheel. That is precisely why we are providing you with a template to get you started. Sure, your end product might be somewhat different from our basic template but, given our insights into the topic, you can rest assured that you're at least starting from a very sound spot.

Due Diligence Galore

A QOE is an opportunity to roll up your sleeves, dig into your operations and historical performance, and provide the outside party an appealing view of your company. Depending on your operations and industry, the due diligence required to create that appealing but accurate view might get a bit intense but, we assure you, it's worth it.

A manufacturer, for instance, will want to highlight any product recalls, quirky R&D costs, or other atypical items that would cloud an otherwise clear view of your cash flow. This could take a bit of time and elbow grease but, as we said, can be instrumental in convincing a buyer or investor to proceed when an initial glance at your financials might indicate otherwise.

Don't Skimp on Your EBITDA

EBITDA isn't the end-all, be-all transaction metric that some believe, but it's still awfully important. Aside from the previously mentioned margin adjustments, you want to present your adjusted EBITDA over an extended timeframe to provide a more far-reaching, comprehensive idea of your cash flow. To get to that point, decide if working with a partner in this area (wink wink, nudge nudge) might help you identify instances that will boost those adjusted margins and shed a more reliable and hopefully better light on your company.

Maintain a Clean House

No one wants to buy or invest into a messy company. Take the perspective of a potential buyer or investor and address any possible issues ahead of time to streamline the process and make life as easy as possible for that outside party. Likewise, you should rightfully assume that a buyer or investor is going to go through your QOE with a fine tooth comb, your adjustments to EBITDA in particular.

Naturally, this is not the time to have long buried skeletons fall out of your organizational closet, so clear up any equity promises, founder issues, accounting deficiencies, employment issues, or anything else that could throw a wrench into the works. Present a neat and tidy image of yourself every step of the way.

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Lastly, remember that, as important as a QOE is to a transaction, it's still merely a single component of an overall financial report that gives a buyer or investor clear, in-depth insights into your company. Your working capital, income statement, balance sheet items, and anything else that might distinguish you are just as critical to the process. So take our wisdom and QOE template, begin your transactional journey, and remember that Embark is always here to lend our hands-on expertise when needed.