Why a Quality of Earnings Report is So Important
Ask any business owner and they’ll no doubt tell you there’s much to consider when contemplating either buying or selling a business. The process can last months or even years as the owner pulls in experts, reviews reports and considers all the facts before signing on the dotted line. A critical piece of this due diligence is the quality of earnings report (Q of E) that provides a detailed analysis of how a company records its revenues, such as cash or non-cash, recurring or nonrecurring. The Q of E report’s goal is to provide assurance that earnings are sustainable and will also translate into cash flows. Reports are usually focused on sustainable earnings before interest, taxes, depreciation and amortization (EBITDA) or free cash flow (FCF). FCF performs an analysis of working capital needs for the business as well as capital expenditures that are needed. Q of E reports are prepared by independent third parties and usually by the buyer or their representative. The seller may also have an independent third party prepare a Q of E report in preparation for a sale.
In this blog we will further define the quality of earnings report, examine why this is a critical report to review during the buy/sell process, and offer a list of the most important components of a reliable Q of E report. You’ll also hear from the CEO of a global manufacturer about what he views as the most crucial takeaways.
Quality of Earnings: What is it?
A Q of E report offers a close examination of company finances. Unlike an audit, Q of E reports typically focus on trailing 12 months (TTM) and usually a few historic periods as well. They are also more focused than an audit. It typically can take anywhere from three to four weeks to complete a Q of E report depending upon the availability of data and management’s responsiveness.
Components: What’s in a Q of E Report?
Q of E reports usually include but are not limited to:
- Executive Summary including a business overview and the transaction overview (if known)
- Income statement section that may include the following:
- Breakdown of revenue by components such as customer/product lines/service lines
- Historical revenue trends
- Determination of one-time income/expenses vs recurring expenses
- Management EBITDA adjustments are analyzed
- Diligence adjustments to EBITDA suggested by the preparer
- Balance Sheet is disclosed and analyzed
- Working capital is analyzed in detail and normalized
- Recommendations and findings by the preparer of the report
Gilmore Jasion Mahler (GJM) consulting and assurance partner Greg Taylor leads the GJM Private Equity Advisory practice and advises many businesses. He views the quality of earnings report as an opportunity to discover any “skeletons in the closet” before due diligence is performed by a potential buyer. Taylor says in the past most Q of E reports were strictly buy-side but in the past few years, he says he’s seen more companies also performing sell-side in preparation for a sale. Many investment bankers are also strongly recommending a Q of E report be performed before they will take the company to market. One thing that hasn’t changed: Q of E reports are frequently prepared by an independent third-party firm.
“Buyers usually want independent parties to perform this analysis for a couple of reasons,” says Taylor. “One: another party is taking an independent look and two: these reports can also be provided to third parties for funding or investment reasons.”
Taylor says there are three key questions business owners should ask themselves when reviewing a Q of E with their financial team and advisors:
- How accurate are the management proposed addbacks?
- How sustainable are the numbers?
- What are other factors that are not just in the numbers, but the intangibles? For example: the management team, market trends and operational expertise.
Findlay-based Rowmark is a leading global manufacturer of sheet plastic for many uses, including signage, awards and other applications. President and CEO Jim Ellward says the company continues to stay active in many acquisitions, and a Q of E report is an important component when exploring any potential acquisition. He has worked with GJM to provide the report to Rowmark when needed.
“You have to have confidence in that third-party advisor that they are going to focus on the details, point out the positive and negative aspects of the business through their findings and truly be that advisor,” says Ellward. “GJM has earned our confidence and we view them as a trusted partner with our business.”
In fact, selecting a professional or firm to provide a quality of earnings report may be equally as important as the report itself. Many firms provide Q of Es, but not all are experts. Ellward says GJM is the right partner for Rowmark.
“Gilmore Jasion Mahler understands our business,” he says. “They have taken the time to learn our business and understand our long-term strategy. This, coupled with their accuracy, attentive service and fact-based assessments, allows us to feel confident with the information and guidance we are able to attain from the Q of E reports.”
Sometimes a Q of E report brings answers a business owner may not be hoping for, but they wind up being the answers that will guide the business in the right direction. Ellward described once such scenario for Rowmark.
“GJM helped us assess a recent potential acquisition that we ultimately decided to pass on as we moved deeper through diligence. Our decision to exit was based on multiple factors regarding the overall health of the business. The Q of E provided the basis of additional questions that we wanted to dive deeper into understanding and in turn allowed us to identify areas of concern and focus on making the right decision for the business.”
Here’s what Ellward says he looks for in a Q of E report:
- A more detailed picture of just how well the business is really doing and whether or not it is worth the price negotiated
- The analysis of customer sales and accounts
- The identification of any significant or unusual accounting adjustments or policies that need explanation
- The ability to see an independent, non-biased view evaluating the on-going operations and cash flows
As this information bubbles up in a Q of E report, the answer often becomes very clear whether it is wise to move forward with the transaction or to walk away and wait for the next opportunity to arise.
Established in 1996, GJM is the largest public accounting firm in Northwest Ohio, with offices in Maumee and Findlay. Locally owned, GJM offers cloud-based accounting and provides comprehensive services including assurance, business advisory, tax, risk advisory, healthcare management and outsourced accounting. The Firm’s professionals specialize in industries including construction & real estate, healthcare, manufacturing & distribution and utilities.