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The Importance of a Quality of Earnings Study

Are you planning to buy a business or sell your own business? If yes, then it is highly recommended to get a Quality of Earnings (QoE) study done. A QoE is a type of due diligencethat is becoming more common in the merger and acquisition practice. It provides buyers with an additional layer of confidence in their potential purchase, and sellers with a view of potential areas that they can address to maximize the company’s market value.

A QoE analysis involves adjusting your typical historical financial statements to reflect the potential future earnings of a business. Various factors can be evaluated and considered to assess the QoE. It can be summarized as the degree to which earnings are cash or noncash, reoccurringor nonrecurring, and based on measurements and estimates that are subject to change. This assessment helps a financial statement user make judgments about current income and the sustainability of future earnings.

Normalizing Adjustments

When a business is being sold, a buyer is most interested in the current and future operations. Historical financial statements, as presented, are not the best indication of a company’s future ongoing operations. Therefore, financial professionals apply “normalizing adjustments” to ahistorical financial statement to reflect the true economic position of the company.

A good starting point that captures four of these normalizing adjustments is EBITDA—Earnings Before Interest, Taxes, Depreciation and Amortization. Each one of these items will be impacted by the structure of the deal and future operations, so they are removed from earnings. This makes EBITA a more accurate measure and more widely used to understand the financial health of a business and its ability to generate cash.

In addition to EBITDA, the QoE analysis will identify other types of adjustments to earnings or cash flow to get a better estimate of the potential earnings or cash provided by the acquired assets or business.

Buy-Side and Sell-Side Quality of Earnings

Traditionally, it is common for the buyer of a business to engage a CPA firm for a financial due diligence QoE study. This is because the final report and analysis provide the buyer with the information they need to make negotiation and purchase decisions. In recent years, sellers have also recognized the value in executing a QoE analysis—for the same reason, to provide the seller with information when negotiating the deal to sell their business. Regardless of whether it is a buy-side or sell-side QoE, the contents of the report are the same.

As the late American Entrepreneur Viktor Kiam once said, “information is a negotiator’s greatest weapon.”