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A Complete Breakdown of a Quality of Earnings Report

Jun 23, 2022

After an exciting and exhausting search process, you’ve finally found a business that checks all your boxes and you’re excited to move forward to the next steps: Signing an LOI and conducting due diligence. Well, now’s the time to do a mini hoorah to celebrate this milestone and hunker down for the rest of the process.

If you choose to go the route that most do and hire a professional due diligence firm to ensure everything checks out, one of the most popular services you’ll encounter is a Quality of Earnings Report or QoE. Now, QoEs provide an incredibly thorough and comprehensive assessment of the business’ financials to ensure no stone is left unturned but the reality is that they can be on the expensive side and aren’t necessary for every single business.

So, we sat down with Fahaad — a highly experienced M&A CPA and Director of Financial Due Diligence here at Rapid Diligence — to break down exactly what’s included in a typical Quality of Earnings, the nuances, and whether you should consider one for your prospective acquisition.

SellerThis refers to the party responsible for the sale of the Company, regardless of whether that is an individual or entity.
BuyerThis refers to the party that has expressed an interest in purchasing the Company, which may be an individual or entity.
Company or target Company or BusinessThe entity for sale by the Seller, which the Buyer has expressed an interest in, typically through a Letter of Intent (LOI).
EBITDARefers to the earnings of a Company before interest, tax, depreciation, and amortization. Most commonly used to determine profitability and valuation during the sale of a Company.
These are terms used throughout this article that we’ve defined to avoid any ambiguities.

What exactly is a Quality of Earnings report?

So, let’s start with the basics. The central concept of a QoE is to eliminate non-recurring and non-operational revenue and expense items, as well as extraordinary events, that are not part of the normal operations. By “adjusting” reported EBITDA, a Buyer can see a normalized snapshot of a target Company’s historical performance and cash flow. Since a Business valuation is often determined based on a multiple of EBITDA, potential Buyers are typically concerned with understanding a Company’s normalized historical and run-rate EBITDA, which is EBITDA based on current financial information as a predictor of future performance.

A good QoE does not hide these adjustments from the P&L but instead removes them from the P&L and justifies their exclusion. The adjusted EBITDA figure gives the Buyer a better idea of what the typical margins of the Business look like without one-off items.

Ultimately, EBITDA is not the end-all, be-all transaction metric that some believe it to be, but it is still incredibly important. Aside from the previously mentioned adjusted EBITDA, the QoE provides a more far-reaching, comprehensive glimpse into the Business’s liquidity, operations, risks, and opportunities than basic financial statements.

A clear and clean QoE report drives:

  • Streamlined transaction
  • Greater transparency and insights
  • A clearer picture of operations

Do I need a Quality of Earnings Report for my prospective business?

Performing a Quality of Earnings analysis during the diligence process is not required but is often a critical component necessary for a successful transaction. Ultimately, it gives the Buyer confidence in the target Company’s financial standing both historically and post-acquisition. 

The reason to get a QoE report is to verify that your investment thesis is based on certainty and be confident that you are making the right decision. The more informed a Buyer is during the process, the better. A close examination of a Business’s records can instill confidence in the quality of the target Company’s financial information, as well as its historical earnings performance. These two factors can significantly affect valuation and forward-looking analyses.

What is the scope of a Quality of Earnings?

A Quality of Earnings analysis is performed to assess and understand a Company’s historical financial performance and trends, working capital considerations, and key policies and accounting processes. This analysis often includes the one or two most recent fiscal years and the last 12-month interim period, often referred to as LTM or TTM.

Although the income statement is the principal focus of the analysis, a QoE also provides insight into other financial statements and facets of operations as well. This includes a closer look at the condition and value of different assets on your balance sheet, key customers, products, working capital requirements of the business and anything else pertinent to the Buyer. It also includes ratio analysis to identify any red flags within the operations of the Business.

Are there different types of QoE reports?

At Rapid Diligence, we offer three types of QoE reports that fit the needs and budgets of our clients:

  • Buy-side QoE: This is what is referred to as a typical QoE analysis. It is due diligence performed on behalf of a Buyer who is interested in acquiring a target Company from a Seller. 
  • Sell-side QoE: This is less commonly performed for every acquisition or investment and is completed on behalf of the Seller. If a Seller decides to engage in a sell-side due diligence procedure, it will occur prior to buy-side diligence. For the most part, this encompasses similar procedures and analysis as buy-side diligence, however, it can differ due to overall bias between a Buyer’s or Seller’s perception of how certain adjustments and historical trends should be interpreted to best present the Company’s financial value.

    Here are a few reasons to perform a sell-side Quality of Earnings analysis:
    • Prepare its management for questions, financial information requested, and the overall process that inevitably will be required from a prospective Buyer
    • Enhance the credibility of the Seller’s proposed valuation of the company
    • Expedite the overall transaction process

  • QoE “Lite”: As the name suggests, this is a “lite” version of our full-fledged Quality of Earnings. This encompasses only a Proof of Cash exercise that traces the Business’ cash flow to bank statements to provide limited comfort on the results reflected in the P&L. This could be beneficial if you have a tighter budget and do not want to perform full-scale financial due diligence but still want peace of mind that the P&L accurately represents the true financial condition of the business from a cash flow perspective.

Besides that, we also provide what we refer to as our comprehensive Live Verification Report here at Rapid Diligence. The Live Verification Report provides insight and commentary into both the operational and financial standing of the company but does not go into the same level of detail into the financials that a QoE report does. This is typically recommended for Buyers who want a slightly higher-level analysis of both the operational and financial aspects of the business and is typically suited for businesses with less complex financials.

What does a QoE Report not include?

Generally, a QoE report does not forecast earnings or do Free Cash Flow (FCF) modeling for valuation purposes. Many Buyers default to EBITDA as a proxy for FCF. A QoE report provides you with easy-to-understand EBITDA numbers. However, unless the target Company does not pay any taxes, has no working capital needs, and does not require any investment in long-term assets, EBITDA may not be the best indicator of free cash flow. In that case, perhaps a free cash flow model would be more appropriate. We can discuss more with you if you require the additional service of a FCF model.

If I get a QoE Report for my prospective business, do I still need to do any other due diligence?

While a Quality of Earnings provides a very comprehensive insight into the target Company’s financials, there is always more to a business than just its financials. Thus, alongside a QoE report, you may need to perform operational due diligence, technical due diligence, and legal diligence.

Don’t let that overwhelm you, though! At Rapid Diligence, we can help you with operational, technical, and financial due diligence — and we can recommend trusted providers for legal due diligence — so you’re in good hands!

Have a question about anything pertaining to a Quality of Earnings report? Feel free to leave a comment below or contact us and we’d be happy to answer your questions!

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Rapid Diligence

Rapid Diligence provides comprehensive and data-driven due diligence services for SMBs at every price range. Whether you’re ready to close or considering buying an online business, we’re here to help!

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