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Quality of Earnings (QofE) Explained:
A Quality of Earnings Report can be a critical tool when buying or selling a business. But what is it, why is it important, and who should get one?
Quality of Earnings (QoE) Reports: A Critical Tool When Buying or Selling a Business
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When you're looking to buy a business or sell a business you built, making sure you are making the best decision regarding your investment is key. The excitement of acquiring a company can sometimes lead buyers to overlook critical financial and operational risks, which is why thorough due diligence is essential to ensure you're making a sound investment. Without a deeper diver into the business’s performance, financial health, and potential liabilities, buyers may end up overpaying, inheriting hidden problems, or facing unexpected financial hurdles. The overall process of due diligence provides a more detailed understanding of what you're really purchasing—helping to protect your investment, avoid unpleasant surprises, and ensure long-term success after the acquisition.
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Similarly, when selling a business, doing the diligence on your own company when preparing for sale can help you maximize the value you will receive, and make the difficult and complicated process of selling much easier.
One due diligence product available is the Quality of Earnings (QoE) report. Unlike a traditional financial audit, which focuses on verifying the accuracy of financial statements according to accounting standards, a QoE report provides deeper insights into the financial health of a business by analyzing the sustainability and quality of its earnings. It seeks to highlight a company’s strengths and identify potential issues within the operations that could affect the health of the company or alter the deal.
In this article, we will explore what a QoE report is, why it is important, who needs it, and the risks you may face if you skip this vital step in the acquisition process.
What is a Quality of Earnings (QoE) Report?
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A Quality of Earnings (QoE) report goes beyond the numbers in a company’s financial statements by providing valuable insights into the company’s operations, earnings and overall performance. It analyzes a company’s true, potentially sustainable earnings by adjusting for non-recurring events, one-off transactions, and accounting policies that might distort the business's actual profitability. Unlike a financial audit, which verifies the accuracy of reported figures, the purpose of a QoE report is to help potential buyers understand the business's long-term earning power and the risks associated with the future performance of the revenue.
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An audit would normally be performed by external accountants to ensure the company’s financial statements comply with accounting standards (GAAP or IFRS). However, they don’t necessarily highlight the sustainability of earnings or provide a clear picture of how well a business is truly performing. This is where a QoE report shines—it focuses on the quality of the company's earnings and their ability to persist in the future.
What is the purpose of a QofE?
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The QofE has one main purpose – to provide a clear, accurate assessment of the company’s true, sustainable earnings. It does this primarily by identifying and adjusting the company’s financial statements (Income Statement, Balance Sheet, Statement of Cash Flows, and possibly others) for non-recurring, irregular, or discretionary items. It also presents analyses to show trending of important financial components of the business:
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One-Time Events: Identifies non-recurring items such as legal settlements, one-off projects, or temporary spikes in revenue.
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Adjustments: The report may adjust earnings to reflect realistic conditions, providing an "adjusted EBITDA" (earnings before interest, taxes, depreciation, and amortization) for better decision-making. In some marketing materials for business sale, you might also see the term Seller’s Discretionary Earnings (SDE), which also approximates the amount of income the business makes for its owner, adjusted for non-recuring events and personal or owner-driven expenses.
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Revenue and Expense Alignment: Along with a deep dive into revenue sources (including customer base, concentration, and quality of recurring revenue), the report will examine operational expenses to ensure they are aligned with the revenue they support. Sometimes, this comes in the form of adjusting from Cash Basis to Accrual Basis accounting. Non-recurring or discretionary expenses are often identified and adjusted for.
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Working Capital and Other Asset Components: Evaluates the company’s ability to cover short-term liabilities and determines what working capital is required to operate the business smoothly.
QoE Report vs. Financial Audit: What’s the Difference?
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It's important to note that a QoE report is not a substitute for a financial audit, and is normally performed as a “non-attest” function, even when performed by a CPA. From a legal standpoint, an audit has greater potential significance (and the rules associated), but a QofE focuses more on the operational significance of the income statement. Here are a few ways that a QofE differs from an audit:
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Objective: A financial audit focuses on the accuracy and compliance of the company’s financial statements with accounting standards (e.g. GAAP or IFRS). A QoE report, on the other hand, focuses on the sustainability and quality of earnings by examining operational performance, cash flow, and adjustments for non-recurring items.
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Scope: An audit is designed to ensure that financial statements are prepared in accordance with accounting standards, and that financial statements are presented fairly and accurately. A QoE report digs deeper into operational factors that could affect future earnings, such as customer concentration, vendor relationships, and recurring revenue patterns. The financial audit may focus more attention on the balance sheet presentation, while the QofE is more focused on operational earnings.
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Perspective: A QoE report is forward-looking, helping you evaluate whether the earnings you see are repeatable and stable. A financial audit is historical, ensuring that the financials from prior periods are accurate and complete.
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Who Needs a QoE Report?
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A QoE report is particularly relevant for anyone considering purchasing or investing in a business. This includes:
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Entrepreneurs Buying a Business: If you're an entrepreneur looking to expand or begin the journey by acquiring a business, you’ll want to be sure you're making a sound investment. A QoE report ensures that you are paying for the real value of the business and not inflated figures that mask underlying issues.
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Private Equity Firms and Investors: Investors rely on these reports to understand the quality of the target company’s earnings and to make informed decisions about whether to proceed with the deal and make sure the value of the business is there.
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Business Owners Preparing for a Sale: If you are planning to sell your business, commissioning a QoE report can help you address potential concerns in advance and present your business more favorably to prospective buyers, ensuring that you understand the value of your business before selecting the listing price.
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What Should Be Included in a QofE Report?
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Every firm performs diligence reporting differently, and factors surrounding the company, industry, availability of information, and other factors will come into play when deciding on the scope of work for a QofE engagement. However, there are several common sections that most QofE reports will have, and some important information you will want to ensure are included when you engage a firm to perform one:
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Dashboard or Executive Summary: Provides an overview of the target company’s operations and details of the transaction, verifying the understanding of the impact of the potential transaction.
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Quality of Income: Since the Income Statement is the primary focus of the QofE, this section should provide details and analysis of the Revenue and Costs including overall trends, detailed breakdowns of revenue and costs by source or character, and identification of risks such as concentration around customer base or product offerings. Revenue and costs that may be non-recurring or not ongoing should be identified here.
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Validation of Assertions: Your desire to purchase the target was probably based on a prospectus, information memorandum, or other offering document that made assertions about the company’s earnings, asset, health and value. The QofE report should validate whether the financial assertions made in the offering documents are reflected reasonably in the diligence documentation. One of the key areas to validate will be any “addbacks” to arrive at Adjusted EBITDA or SDE. While the QofE is not a valuation and will not provide any assurance of the value of the target, it can validate some of the assertions that underly the valuation.
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Other Analyses: Depending on the scope of the engagement, a QofE report will most likely report on some items in the Balance Sheet as well. Common areas of reporting may be on the quality of assets (such as accounts receivable and inventory) and liabilities (such as accounts payable, accruals, or debt). Analyses in this section might include trending A/R “agings” to show how customers pay, historical write-off levels, inventory levels and movement or “turns” to indicate possible excess or obsolete inventory items, accruals such as allowances for warranties and returns, payroll, customer deposits, or any others commonly missed in small-company accounting. Other important areas that should be addressed are Net Working Capital (or the amount of liquid and semi-liquid assets inherent in the value of a business), Fixed Assets (such as equipment, facilities, leasehold improvements, and other long-lived asses that may have an impact on the business), and net equity.
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Identification of Risks: A conclusion and summary of the findings of the report, potential issues and recommendations.
Why a QoE Report is Critical for Buyers
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The entrepreneurial spirit often drives people to make fast decisions, especially when a business opportunity presents itself. But without a thorough QoE report, you could be walking into a financial trap. Here’s why you shouldn’t skip this step:
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Expose accounting issues: While the QofE is not an audit, it is designed to find significant issues with the accounting and make estimated or actual adjustments to account for the issues. This provides a clear list of the accounting issues in the target company, either so that you can rectify them after acquisition or not acquire the company, especially if the issues are serious.
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Avoid Overpaying for a Business: Without a QoE report, the financials of the business may appear healthier than they actually are. Because business value is highly interrelated with the earnings, you may end up overpaying for inflated earnings or non-sustainable revenue.
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Identify Potential Risks: The report helps uncover potential risks, such as customer concentration (where too much revenue comes from one client), hidden liabilities, or unreported operational challenges.
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Ensure Realistic Cash Flow: A QoE report verifies that the business generates consistent, reliable cash flow. This is critical for assessing whether the business can continue to operate successfully after the acquisition.
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Assist with Financing: Lenders sometimes require a QoE report to assess the risk of financing your acquisition. Even without the requirement, though, a thorough report improves your credibility with banks or investors.
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Why a QoE Report is Critical for Sellers
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A QoE report can be highly beneficial for a seller, not just a buyer, when preparing to sell a business. For sellers, a QoE report helps highlight the true financial health and profitability of the business, providing transparency and building trust with potential buyers. This proactive step allows sellers to:
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Expose accounting issues: Wouldn’t you want to know about accounting issues before your buyer finds them in the diligence process? It would give you the chance to fix the issues and present clean and cohesive financials, which will make the entire process go smoother and inspire confidence in the company you created.
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Expedite the sale: By having a QofE in hand that you could provide to potential buyers, it shows you’re prepared and ready to sell and potentially saves the buyer time and money. The report will help you anticipate questions that buyers may ask and have answers ready for them, resulting in fewer “surprises” common in the diligence process and avoiding the typical delays and issues they cause.
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Support the Asking Price: By basing your expected price on the earnings within the QofE report, it is less likely that you will be re-negotiating with the buyer after they order the QofE and find adjustments to your earnings.
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Increase Byer Confidence: Buyers appreciate transparency, and providing a QofE report to them demonstrates that you as a seller are open and well-prepared. Not only can it speed up the sale process, but it could improve the buyer’s satisfaction with the process and ultimately make a better transfer experience for everyone involved.
The Risks of Not Having a QoE Report
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Failing to conduct a QoE analysis before buying a business can lead to significant financial and operational risks. Here are some potential dangers:
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Unforeseen Financial Issues: Without a QoE report, you might not realize that the business has non-recurring income that artificially boosts profitability. This could leave you stuck with a business that isn’t as profitable as you were led to believe.
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Inaccurate Valuation: The business’s value may be overstated without the adjustments and insights provided by a QoE report. You could overpay significantly, making it hard to see a return on your investment.
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Surprise Liabilities: A QoE report uncovers hidden or unexpected liabilities, such as underfunded pensions, unpaid taxes, or pending lawsuits. Missing these liabilities can lead to financial headaches after the deal is closed.
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Inability to Secure Financing: Without a QoE report, you may struggle to secure loans or funding, as potential lenders won’t have the clarity they need to assess the viability of the acquisition.
Conclusion: Protect Your Investment with a QoE Report
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Making an acquisition can be an exciting opportunity to expand your business or a great way to own your first business. However, it’s essential to be armed with all the right information before making a decision. A QoE report is a crucial tool in your due diligence arsenal, ensuring you have a full and clear understanding of the business's financial health.
Skipping this process could leave you vulnerable to unexpected costs, inaccurate valuations, and even potential business failure. Protect yourself, and your investment, by making sure a Quality of Earnings report is part of your acquisition strategy.
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