In mergers and acquisitions, potential buyers as part of their due diligence may obtain a quality of earnings (QOE) report to evaluate the validity and sustainability of the seller’s reported earnings. It is also not uncommon for companies contemplating a sale to obtain their own QOE reports to spot potential problems that might derail a transaction and identify ways to preserve or even increase the company’s value.

How Do QOE Reports Differ from Audits?

A financial statement audit yields an opinion on whether a company’s financial statements fairly present its financial position in accordance with Generally Accepted Accounting Principles (GAAP) without material misstatement. It is based on historical results as of the company’s fiscal year end.

In contrast, a QOE report determines whether a company’s earnings are accurate and sustainable and whether its forecasts of future performance are achievable. It typically evaluates performance over the most recent interim or trailing 12-month period.

What Affects Earnings’ Quality?

Generally, the starting point for a QOE report is the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a company’s ability to generate cash flow than bottom line net income. In addition, EBITDA helps filter out the effects of capital structure, tax status, certain accounting policies and other strategic, operational or financial decisions that may vary depending on who is managing the company.

The next step is typically to “normalize” EBITDA by:

• Eliminating certain “one time” or nonrecurring revenues and expenses;
• Adjusting owners’ compensation and benefits to market rates;
• Evaluating related party expenses, such as building rent or transactions with affiliates, and adjusting those operational expenses to competitive market amounts; and
• Adding back certain other perks and discretionary expenses which may be beyond the norm given industry standards, operational needs or market conditions.

Additional adjustments may be needed to reflect industry accounting conventions. Examples include valuing a manufacturer’s inventory using the first-in, first-out (FIFO) method rather than the last-in, first-out (LIFO), recognizing revenue based on the percentage-of-completion method rather than the completed-contract method, and assuring that beginning and end of year methodologies for estimating reserves for uncollectible accounts receivable, obsolete inventory, warranties or returns are consistent with industry standards.

A QOE report identifies factors that bear on the company’s continued viability as a going concern, such as operating cash flow, working capital adequacy, equipment needs, related-party transactions, lease commitments, customer concentrations, supply chain stability, management quality and succession planning. A QOE report can scrutinize trends to determine whether the company’s operating results are truly reflecting improvements in earnings quality or if potential red flags exist.

For example, an upward trend in a manufacturer’s EBITDA could be caused by increasing sales (a positive indicator of future growth) or decreasing costs (a sign that management is being more fiscally responsible). However, the increasing sales figures could be a result of accounting revenue recognition methods, which is unrelated to real economic improvements, and decreasing costs could be a result of deferred spending on plant maintenance or equipment, a sign that the company is not reinvesting enough in its future.

A Valuable Tool

Whether you are buying or selling a business, or simply looking for ways to improve performance, a QOE report is a powerful tool. It goes beyond the financials to provide insight into the factors that drive value.

For more information, contact your ORBA advisor or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.