By: Patrick Ungashick
A frequent question we hear from business owners contemplating a sale of their company is “What is a Quality of Earnings (QofE) study?” Owners are asking because it has become increasingly common that potential sellers are advised to get a QofE study as part of their preparations. This article explains the concept of quality of earnings, shows how a QofE study is different from an audit, and highlights the significant advantages that business owners create by securing a QofE study before launching a process to sell their business.
What is Quality of Earnings About?
Quality of earnings (QofE) refers to the extent to which a company's reported earnings accurately reflect its true financial performance and the sustainability of its earnings over time. It is a measure used by buyers to assess the reliability and integrity of a company's financial statements.
The concept of QofE recognizes that not all earnings are created equal. Some earnings may be more sustainable and reliable, while others may be subject to manipulation or distortion. Therefore, evaluating the quality of earnings helps potential buyers gain a better understanding of the underlying economic reality of a company and make more informed investment decisions.
There are several factors that can influence a company’s quality of earnings:
- Revenue Recognition: The timing and accuracy of revenue recognition are crucial. Companies should follow appropriate accounting standards and policies to recognize revenue when it is earned and realizable. Aggressive revenue recognition practices or manipulations can inflate earnings artificially.
- Expense Recognition: Similar to revenue recognition, expenses should be recognized in the appropriate period and matched with the related revenue. Delaying or manipulating expenses can boost earnings in the short term but may not reflect the true cost of generating revenue.
- Accounting Policies: The choice of accounting policies can impact the quality of earnings. Companies have some discretion in applying accounting rules, and different policies can lead to different earnings outcomes. Transparent and conservative accounting policies tend to enhance the quality of earnings.
- Non-recurring Items: Earnings can be affected by non-recurring or one-time events, such as gains from the sale of assets or restructuring charges. These items should be properly disclosed and excluded from the assessment of ongoing earnings quality.
- Cash Flow Analysis: Analyzing the company's cash flow statement can provide insights into the quality of earnings. Positive operating cash flow that aligns with reported earnings suggests healthier earnings quality, while significant disparities may raise concerns.
- Financial Ratios: Assessing financial ratios, such as return on equity (ROE), return on assets (ROA), or gross margin, can help evaluate the sustainability and profitability of earnings. Consistent performance and improvement in these ratios over time indicate better earnings quality.
- Transparency and Disclosure: Companies that provide transparent and comprehensive financial reporting, including clear footnotes and explanations, inspire confidence and enhance the quality of earnings.
It's important to note that evaluating the quality of earnings requires a thorough and independent analysis of financial statements, including the income statement, balance sheet, and cash flow statement, as well as an understanding of the specific industry dynamics and accounting standards.
The Role of a QofE Study in Selling a Company
For many years, buyers contemplating acquiring a company often would commission a QofE study as part of their deep due diligence on that target acquisition prior to closing on the sale. Potential buyers used the QofE study to generate an accurate understanding of the company’s historical earnings, create confidence (or lack of) in the target company’s forecasted future earnings, and reduce their risk in the transaction. In some situations, potential buyers may use the QofE study’s results to reduce their offer price or proposed terms if their study claims the company’s true earnings were less than originally stated.
Given the importance that buyers were placing in the QofE, it did not take long for sellers to catch on. In what is often called “seller due diligence”, business owners contemplating a sale of the company are often commissioning their own QofE study prior to marketing the company for sale. By doing their own QofE study, potential sellers can:
- Validate earnings and projections: A comprehensive QofE analysis verifies the accuracy and reliability of reported earnings. This validation is particularly crucial when presenting historical financial statements and projecting future earnings to potential buyers. By substantiating the earnings figures and highlighting any adjustments made during the analysis, the company can strengthen the credibility of its financial information and support the future earnings projections provided to buyers.
- Identify and address earnings risks: A QofE analysis helps identify any potential risks or inconsistencies in the financial statements. By conducting an internal review, the selling company can proactively address these issues, rectify any errors, and provide explanations or disclosures for any non-recurring items or accounting policies that may impact the earnings. This process helps reduce uncertainties and potential deal roadblocks during buyer due diligence.
- Enhance financial transparency: The QofE analysis involves a thorough examination of the company's financial statements, accounting practices, and underlying business operations. By conducting this analysis, the company can enhance its financial transparency and provide clear explanations for its revenue recognition, expense management, and overall financial performance. Transparent financial reporting instills confidence in potential buyers and helps build trust during the sale process.
- Mitigate buyer concerns: Buyers often have concerns about the sustainability and quality of a company's earnings. By conducting a QofE analysis, the selling company can proactively address these concerns. It allows the company to explain the key drivers of its earnings, demonstrate the sustainability of revenue streams, and provide supporting evidence for its financial performance. This mitigates buyer skepticism and facilitates a smoother transaction process.
- Maximize company valuation: A robust QofE analysis provides buyers with a clear understanding of the true financial performance and potential of the selling company. By demonstrating the quality and reliability of earnings, the company can maximize its valuation and potentially attract more favorable offers. A strong earnings profile makes the company more attractive to potential buyers and increases its bargaining power during negotiations.
- Get a jump start on organizing the financial data and records that will be necessary to provide potential buyers during due diligence, which saves time and reduces pressure on the business owner and his or her team once the sale process begins.
Perhaps the bottom line is that by proactively getting their own seller QofE, business owners reduce their risk, protect their leverage in the negotiation process with potential buyers, and support getting the maximum potential value for the company at sale. Given all the advantages, at this point most of our exit planning clients now secure their own QofE study as one of the steps to prepare for sale.
How is a QofE Study Different from an Audit?
Quality of earnings (QofE) and audit are related concepts but have distinct meanings and purposes.
Quality of earnings refers to the assessment of the reliability and sustainability of a company's reported earnings. It focuses on evaluating the accuracy and integrity of the financial information disclosed by a company, specifically its income statement, to determine the underlying economic reality. QofE helps buyers understand whether the reported earnings are a true reflection of the company's performance and financial health.
On the other hand, an audit is a formal examination and verification of a company's financial statements and related records by an independent third-party auditor. The purpose of an audit is to provide an opinion on whether the financial statements present a true and fair view of the company's financial position and performance in accordance with applicable accounting standards. The audit process involves conducting tests and procedures to gather sufficient evidence about the financial information, assessing the company's internal controls, and issuing an audit report with an opinion on the reliability of the financial statements. The primary objective of an audit is to enhance the credibility and reliability of the financial statements for the benefit of shareholders, stakeholders, and regulatory bodies.
Many privately owned companies do not have audited financial statements, and most have had no reason to do a QofE study prior to contemplating a sale of the business. Business owners should consult with their advisors about the need for an audit and/or a QofE study prior to pursuing a sale of the business.
Overall, conducting a QofE study as part of preparing a company for sale helps build credibility, transparency, and trust with potential buyers. It enables the selling company to address any concerns, enhance financial reporting, and optimize its valuation in the transaction process.