Sell-Side Quality of Earnings

Uncovering a financial or operational issue from your company’s financial statements or earning report that neither you nor the investment banker knew about can reduce your business’s valuation. One way to avoid these surprises is to carry out what is called quality of earnings analysis during due diligence.

Key Takeaways

• A QoE report does more than review financial statements; it protects the seller from common pitfalls, including unforeseen financial liabilities, which are hidden risks like customer dependency, non-compliance with taxes, and overlooked regulatory issues. It also examines overly optimistic valuation expectations and reduces the regular slow processes of business sales.
• A quality of earnings report drills deeper than audits and normalizes earnings by adjusting for anomalies like one-time expenses. It includes Adjusted EBITDA, Working Capital, and Debt-Like transactions.
• A sell-side QoE is a critical part of due diligence. It helps sellers identify potential red flags, enhance financial transparency, and increase value. Understanding and resolving financial challenges in advance can make or break a successful and profitable sale for business owners.

What is a Quality of Earnings Report

For sellers, a Quality of Earnings Report is not just about financial statements; its purpose and objectives are centered on providing a protective mechanism that makes the selling of your business as smooth and successful as possible. It protects you from common pitfalls such as:

• Unforeseen Financial Liabilities: Most business owners are blind to some risks in their finances, which may include too much reliance on a few customers, non-compliance with taxation, or one-off revenue items. Or even a complete oversight of some regulatory framework and standards
• Overoptimistic Valuation Expectations: Sellers often feel they know the value of their business, but if earnings are not correctly adjusted, they may be surprised when buyers make offers.
• Slow or Chaotic Processes: Poor bookkeeping can really slow down a deal. If your books aren’t in order, you might face frustrating delays in the middle or at the end of the transaction. The components of a QoE report cover all these lapses.

While a buy-side QoE is a report that seeks out risks after the signing of a Letter of Intent, a sell-side QoE helps sellers identify potential issues before the business goes on the market, thus providing time to fix problems and present the best face.

Quality of Earnings Analysis Process

While audits will validate the precision of the financial statements, a QoE report goes one level deeper: looking at what actually comprises those earnings through benchmarking and trending, for example, and then “normalizes” your performance through revenue recognition analysis by identifying one-time non-operating expenses or owner-specific expenses, eliminating items that may represent financial anomalies. A good QoE report covers the following:

• Adjusted EBITDA: This is one of the key ways purchasers value your enterprise. A QoE normalizes EBITDA for one-time, personal, and non-operating expenses with expense analysis and classification.
• Working Capital: Any transaction requires a certain amount of working capital to be conveyed. A QoE ensures this amount by analyzing and normalizing working capital using a special assessment that accounts for seasonal and non-recurring changes.
• Debt-Like Items: Items like deferred compensation, tax liabilities, or unpaid bonuses may be considered huge liabilities against the purchase price of your business. A QoE spots these liabilities at the outset.

Due Diligence Integration

A sell-side quality of earnings analysis plays a significant role in M&A transactions. It provides a detailed review of a company’s financial condition that can highlight potential red flags or areas of concern for sellers well before a buyer’s due diligence process. Doing a QoE before putting your business on the market will help you better understand how your business finances increase the chances of a successful sale and command a higher selling price.

A due diligence process aimed at establishing the quality of earnings involves a thorough financial analysis of your company. Its documentation requirements usually include an analytical review of the company’s company’s financial statements, along with a detailed analysis of its revenues, expenses, and profits. The process also comprises an assessment of the company’s management, operations, and headcount.

Due diligence is usually carried out by a financial expert and is designed to provide perspective to prospective buyers, investors, or lenders to help these individuals make decisions based on the perceived value and/or potential success of the company in question. Quality of Earnings works well with integration with other due diligence work streams.

FAQs

1. What is the Quality of Earnings?

The quality of earnings refers to the validity and sustainability of a business’s earnings reports beyond what its financial statements show. A Sell-Side Quality of Earnings report digs deeper to analyze sources and consistencies in earnings generation against anomalies like one-time expenses or revenues that are not operating.

2. Why is a Sell-Side Quality of Earnings report critical?

A QoE report is paramount for sellers to illuminate financial risks, such as hidden liabilities or dependence on specific customers, prior to marketing the business. This ensures that financial adjustments are correctly made, there are no valuation surprises, and bookkeeping issues are sorted out, which could delay or kill the transactions.

3. What does a Quality of Earnings report include?

A Quality of Earnings report examines such key financial areas as Adjusted EBITDA, working capital, and debt-like items. It normalizes earnings by removing anomalies, assesses trends in recurring revenue, and underlines liabilities that may impact the purchase price.

4. How does a QoE report integrate with due diligence?

A sell-side QoE supplements due diligence with a detailed financial review that highlights and resolves issues at an early stage. It ensures transparency in the seller’s position, instilling confidence among potential buyers and ensuring a successful transaction.

Key Points

Investment bankers are not there to help you with SBA financing but can guarantee a perfect sell-side quality of earnings analysis that gives you an edge during the period of the business sale. WebsiteClosers.com is there for you!