Quality of earnings reports are an increasingly common part of the merger and acquisition process, but some buyers and sellers of small businesses may hesitate to make the investment. They might skip the report altogether or opt to conduct their own financial due diligence analysis. These parties can end up regretting their decision, though, and end up on the wrong end of a bad or even fraudulent deal.

The Quality of Earnings in a Nutshell

A quality of earnings report provides detailed information on a small business’s operations, financial performance, and earnings, including adjustments for things like accounting errors and nonrecurring events. It goes beyond a simple review of the company’s financial statements and digs into the seller’s discretionary earnings (SDE) — generally, the net income plus the owner’s salary, perks, and other discretionary expenses. The result is a fuller assessment of the business’s revenue stability and potential earnings.

“Quality of earnings” essentially is a measure of risk. “High quality” earnings are stable, sustainable, recurring, and reflect a solid cash flow. They usually are driven by high sales and controlled costs. “Low quality” earnings are less reliable or may be tied up in accounts receivable. They suggest that the purchase of the business might be higher risk but do not necessarily indicate that the business itself is in poor financial health.

No bright-line test exists for determining the quality of earnings. Quality is evaluated based on factors such as:

• Whether earnings are cash or noncash and recurring or non-recurring;
• Revenue sources and types;
• Amount of working capital;
• Asset performance; and
• Capitalization structure.

A quality of earnings report is best prepared by an independent qualified expert who can bring an unbiased perspective to the task. These experts typically have worked on both sides of transactions and therefore understand what each side is most likely to prioritize and scrutinize. They can, for example, note issues that a seller might be blind to but would catch the attention of a prospective buyer.

Some parties to the sale of a small business may mistakenly believe that an audit provides them sufficient information, but audits and quality of earnings reports are quite different. For example, an audit is retrospective, objective and primarily concerned with compliance with Generally Accepted Accounting Principles. A quality of earnings report is more forward-looking and focused on earnings. It also takes into account some vital subjective factors, such as industry and economic trends that are not considered in audits.

The Benefits for Sellers

Undergoing the process required to produce a quality of earnings report demonstrates your commitment to selling your business. It highlights your transparency and enhances your credibility.

Equally important, the report will identify strengths and weaknesses in your business, including potential red flags that could blow up a deal. The earlier you learn of problems, the more time you have to mitigate or eliminate them.

It generally is preferable to learn of any troublesome issues before you accept a letter of intent — when you may be entertaining multiple potential buyers — than after. If problems are not discovered until you are down to haggling with a single buyer, the buyer will gain valuable negotiating leverage and could even walk away if you do not reduce the price. The buyer also might question your integrity. It may then perform more intense due diligence or insist on burdensome provisions to increase its protection. On the other hand, you can stand firm if you have distributed a quality of earnings report to multiple bidders and maintained interest from several potential buyers.

The quality of earnings report is not only about uncovering looming problems, though. It also can reveal previously unknown adjustments to SDE that boost the business’s profitability and, in turn, the sales price. The report helps you set a fair and defensible price, as well as the working capital target. Additionally, it gives you a leg up on the impending due diligence process. You already will have collected much of the requisite information and documentation, and the expert who prepared the report will be well-armed to promptly address the buyer’s concerns.

The Benefits for Buyers

Buyers, too, stand to benefit from a quality of earnings report. First and perhaps foremost, skipping a quality of earnings report could mean significantly overpaying for a business. A report will give you an assessment of whether the SDE figure and related assumptions are accurate or require adjustments or add-backs. It ensures that earnings are not inflated and accounting practices are acceptable.

With a quality of earnings report in hand, you will have a better understanding of the business and greater confidence that you are getting what you are paying for. You would not buy a used car without consulting a mechanic, so it only makes sense to have a qualified expert “look under the hood” before you make a much larger and more consequential purchase.

A report also can help you obtain financing. It will give lenders a better grasp of the amount of debt the company can reasonably service. Similarly, the report may prove helpful with landing approval of a deal from your board of directors.

The Elephant in the Room

For all of the benefits of a quality of earnings report outlined above, parties to the sale of a small business understandably may be reluctant to go that route. After all, you could spend thousands of dollars on a deal that never comes to fruition. Or you might just think that a full report is not necessary for a small “mom-and-pop” shop.

You could be right about that, depending on the business and the industry. The good news is that quality of earnings reports can be tailored to the size of the target company, from lengthy and extensive to shorter and less in-depth. Several scopes and a range of fees are available.

Look Before You Leap

Obtaining a quality of earnings report makes sense for both sellers and buyers, regardless of the size of the target business. The upfront investment in an unbiased report from a qualified expert can more than pay for itself in a fair sales price, easier negotiations and a speedier overall process with few or no unwelcome surprises along the way.

If  you would like more information, contact Luca Pescarini at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Transaction Advisory Services.