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April 3, 2023

How to find quality in a ‘quality of earnings’ report

Buyers looking to acquire a company need solid, accurate and reliable data to make the most informed decisions possible about the business they are targeting.

This is always true, but today, with an uncertain economic picture both in the U.S. and abroad, it’s more crucial than ever.

Baker Newman Noyes
Scott McKenzie, a CPA and principal at Baker Newman Noyes

This is where a "quality of earnings" report, or QoE, comes in. QoEs, which are provided by an independent third party, can provide important information about an organization’s finances and tax compliance.

What is a ‘quality of earnings’ report?

Quality of earnings focus on the normalization of earnings before interest, taxes, depreciation and amortization (EBITDA). Normalization refers to the process of adjusting management reported EBITDA to eliminate certain one-time or non-recurring transactions, correct errors, and add back non-cash transactions so that a potential buyer has a better understanding of the earnings they can expect from a business.

This metric is among the most important to determine and analyze when contemplating a purchase, as it’s considered a critical element for buyers in building a valuation model and is often the basis for purchase price negotiations. A QoE can help investors and potential buyers get a better picture of a company’s pre-tax cash flows. 

QoEs can also identify and address accounting errors. The third-party undertaking a QoE project will obtain an understanding of a company’s accounting policies and ascertain if its financial statements are in compliance with generally accepted accounting practices and adjust as needed.

Telling the story of your business

Every number in a company’s transaction ledger tells a story. A QoE is a way of contextualizing those stories so a buyer knows which stories are established recurring costs for the business and which won’t necessarily be factors for the way a new owner/operator will plan on operating the business in the future.

For example, let’s say a real estate agency is in the process of being sold to a venture capital firm. The agency also owns a small cleaning company on the side that is not part of the sale. The real estate firm is paying higher than market rates for employees at the cleaning company because they control both businesses. These higher prices would not transition to the buyer because they are a direct result of the current company’s ownership structure and not part of standard business operations. This discrepancy is something that would be captured in a QoE, with the overall cost adjusted and reflected in the valuation of the business.

Trust and verification

Ultimately, due diligence services such as a QoE are about transparency and trust. The goal of a QoE is to give all parties, particularly the buyer, an accurate picture of the day-to-day financial investment of running the business. It can help potential buyers review and assess the financial areas to guide decision-making with a potential investment or acquisition decision.

QoE is just as important on the sell-side; it can help identify, and in some cases correct, issues prior to engaging with an investor or buyer.

In uncertain economic times, you can cut back on non-necessary expenses, but you can’t cut corners when it comes to credibility.

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