Quality of Earnings Report: Should I Get One?

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I’ve been asked several times: “Should I get a quality of earnings analysis for my deal?”. I’ve also had discussions with many searchers who decided against it because they didn’t think it was important (and justified the cost) or the lender on their deal didn’t require it.

I would argue that a quality of earnings (QoE) analysis is critical in smaller transactions because you’re dealing with businesses that don’t have proper finance departments (and therefore reporting), don’t go through regular audits, and might take liberties with add-backs and adjustments.

It might be one of the more important aspects of financial diligence you can do.

Before you overlook a QoE, ask yourself this: Would you buy a used car without having a mechanic inspect it? Or a home without having a home inspector do a walk through? A QoE provider is akin to that mechanic or home inspector taking a peek under the hood or taking a look around your crawl space.

Let’s dive into what a QoE covers and why it’s important.

What is a QoE?

A QoE is a detailed financial analysis that assesses the quality and sustainability of a company’s earnings. At its core, it’s attempting to answer whether certain revenue items or costs are derived from principal business activities, or one-off and non-recurring in nature. In SMB deals, mixing personal and business expenses is quite common, and add-backs (as reported by the seller) tend to be pretty significant.

A QoE is typically carried out by CPA firms or specialized financial due diligence firms. At AppHub (my last business), we engaged a Big 4 accounting firm (KPMG) to conduct this analysis for us each time we acquired a new business.

A QoE is different from a financial audit (where the balance sheet is the primary focus). This gives you greater flexibility in terms of approach and scope. The materiality (and therefore cost) is much lower than an audit.

How much does it cost?

For SMB acquisitions, I’ve seen it run in the range of $15-30k. It could be more or could be less, and it depends on your exact scope.

If you’re using debt to finance your acquisition (as most searchers do), you can usually roll the cost of the QoE into your total use of funds and have a large portion of it financed by the lender.

For a deal size of $2m+, I think the cost (~1% of deal value) is well worth the peace of mind. I would argue that it’s also worthwhile for smaller deals but it all depends on your risk tolerance.

What exactly does a QoE cover?

Here’s a table of contents from a QoE provider I’ve worked with before:

There are three main aspects of the report that I think are important for SMB deals and worth including. If nothing else, consider doing 1 and 2 at least. I’ve also included illustrative outputs from reports I have on hand.

1. Quality of earnings – this is where you’re taking the Revenue and EBITDA as reported by the company and making certain adjustments. Often, the seller will make certain adjustments and add-backs to EBITDA. The QoE provider will attempt to validate these adjustments by obtaining original documentation and challenging their rationale. In addition, the QoE might include certain other adjustments identified by the due diligence team / buyer (overlooked one-time expenses, accounting errors, effects of unrecorded liabilities or even a reversal of the seller’s adjustments that fail to hold up to scrutiny). The QoE will also make pro-forma adjustments (if relevant) to “normalize” earnings for the entire diligence period (i.e., salary of an employee that was hired mid-year being annualized for the whole year).

2. Cash deposits to revenue comparison (or Proof of Cash) – I would argue that this is one of the most important features of a QoE in a SMB deal. This is where the QoE provider will verify the cash balances of the business by reviewing bank statements, cash receipts, and other financial records to reconcile reported revenue to cash deposited in the bank. This is answering “is the business actually making as much money as it claims”.

3. Net working capital – a detailed analysis of net working capital over historical periods to determine a “normalized” level. This analysis often informs your net working capital “peg”, with any amounts over or under at closing reflected in a purchase price adjustment. It should be the buyer’s expectation that the seller leave the business with a normalized level of working capital at close, regardless of if it’s an asset or stock deal, and even if done on a cash-free, debt-free basis. In the latter case, net working capital calculations should exclude cash and debt.

Illustrative outputs

Conclusion

Given the flexibility in scope and pricing, I would highly recommend that every searcher consider doing a QoE. QoE providers are extremely skilled at conducting financial due diligence (this is what they do every single day) and identifying issues that can swing numbers in either direction. Even a $50k downward adjustment in EBITDA can have a meaningful impact on valuation in smaller deals. Consider it an insurance policy so you can sleep better at night.

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