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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 (QofE) comes into play. With many details not outlined in the income statement, the QofE permits 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 QofE is likely outside of a CFO and 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 QofE as well as the need for some guidance and direction. Therefore, since we firmly believe sharing our knowledge rather than hoarding it like Pokémon cards is in everyone's best interests, we're providing our insights into the QofE along with a handy Excel 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 a hefty valuation and successful transaction.
The Essence of Your Financial Health
One of the central concepts of a QofE is to eliminate any skewed perspectives resulting from non-recurring items or extraordinary events 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 QofE takes those items out of the loop to present a normalized snapshot of your company’s performance and cash flow.
As you'll see from our accompanying Excel template, a properly constructed QofE 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 analysis, a QofE also provides insights 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 QofE 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 from an outsider like private equity can be stressful enough without placing undue and unfamiliar responsibilities on your team. For many firms, a QofE, 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. Thus, 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 QofE doesn't require you to reinvent the financial reporting wheel. That is precisely why we're 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 QofE 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 financial due diligence required to create that appealing but accurate view might get a bit intense. We assure you, however, that 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 free 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 operating expenses or recent financial performance might indicate otherwise.
Don't Skimp on Your EBITDA
EBITDA isn't the end-all, be-all transaction metric that some believe it to be, but it's still awfully important. Aside from the previously mentioned gross margin adjustments, you want to present your adjusted EBITDA over an extended timeframe to provide a more far-reaching, comprehensive glimpse into your liquidity than a basic cash flow statement might provide. 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 flattering light on your company.
Maintain a Clean House
No one wants to buy or invest in 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 QofE 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, GAAP – and any other – accounting deficiencies, employment issues, or anything else that could throw a wrench into the works. Present a high-quality, neat and tidy image of yourself every step of the way.
Lastly, remember that, as important as a QofE 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 accounting policies, capital expenditures, working capital, net income, liabilities – and other balance sheet items – as well as anything else that might distinguish you, are just as critical to the process. So take our wisdom and QofE Excel template, begin your transactional journey, and remember that Embark is always here to lend our hands-on expertise when needed.