Navigating Your Business Acquisition

The Role of Quality of Earnings Assessment in the Deal Process

As an acquisition entrepreneur you’ve probably heard of a “quality of earnings” (QoE) assessment and wondered if you really needed one. Overall, a QoE helps buyers, investors, and lenders make informed decisions through a comprehensive review of your target’s earnings quality and financial health. The QoE is focused on the sustainability and accuracy of reported financial results. It provides insight into the reliability and risks associated with earnings.

Here’s what you’d typically find in a QoE assessment for a small business:

• Revenue Analysis: This section examines the sources of revenue, ensuring they’re recurring and sustainable. It checks for any unusual spikes or dependencies on key customers (customer concentration).
• Cost and Expense Analysis: This part reviews the company’s expenses to determine if they’re in line with industry norms and sustainable. It looks at cost of goods sold, operating expenses, and administrative costs.
• Non-Recurring Items: This part identifies any one-time gains or losses that might distort earnings, such as asset sales, legal settlements, or restructuring costs.
• Profit Margins: This part assesses gross, operating, and net profit margins to evaluate the company’s profitability and compares it to industry benchmarks.
• Cash Flow Analysis: This part focuses on the cash flow from operations, ensuring the business generates enough cash to support its operations without relying on external funding. (You can do a quick and dirty check by using a Quality of Earnings Ratio: Earnings-Cash from operations / Assets).
• Balance Sheet Review: This section checks the company’s assets, liabilities, and equity to determine financial stability. It looks for red flags like excessive debt or aging receivables.
• Adjustments and Normalizations: To get a clear picture of true earnings, the report adjusts for anomalies and normalizes earnings to reflect typical business operations.
• Working Capital Requirements: This part analyzes the company’s working capital to ensure it’s sufficient for ongoing operations and growth.
• Industry Comparisons: The QoE report will often include a comparison to industry peers.
• Management Quality and Key Personnel: It assesses the quality of the management team, their experience, and the risk associated with key personnel changes, assuming you won’t be taking over as operator.

But should you shell out for a QoE? Yes, in fact, it is generally considered important to hire an outside firm to conduct a QoE.

Here are a few reasons why this is advisable:

• Objective Analysis: An outside firm provides an unbiased, objective analysis of the financial health of the business without conflicts of interest.
• Expertise and Experience: Specialized firms have expertise in forensic accounting and financial analysis, and understand what to look for in terms of potential red flags and inconsistencies.
• Risk Mitigation: A QoE report helps identify any overstatements of income or understatements of expenses and liabilities. It also exposes hidden problems such as irregular revenue recognition, one-time sales, or unsustainable profit margins.
• Negotiation Leverage: Detailed insights from a QoE can provide significant leverage in negotiations. Buyers can use the findings to argue for a lower purchase price or better terms.
• Financing: Lenders or investors may require a QoE report before they commit funding for the acquisition. Demonstrating due diligence through a professional QoE assessment should make it easier to secure financing.

So what’s it going to cost? The typical QoE runs about $12k to $25k, depending on the complexity of the business. Most acquisition entrepreneurs using investors or debt to finance their deal can roll the cost of a QoE assessment into the business acquisition at closing.

A QoE assessment is typically a worthwhile investment compared to the potential risks of overpaying for a business or inheriting undisclosed financial problems. It may even be required.