Due Diligence: Quality Of Earnings

Due Diligence: Quality Of Earnings

An image of a quality of earnings assessment during due diligence at a retail chain.

Key Takeaways About Quality of Earnings:

The purpose of this guide is to walk you through what a quality of earnings assessment is in due diligence. Here are some key takeaways regarding quality of earnings:

  • Quality of earnings reviews are a type of financial due diligence typically performed in an M&A deal.
  • The buyer will normally hire an accounting firm to conduct this quality of earnings review for them.
  • The purpose of this is to determine if earnings have been accurately reported and adjusted. Additionally, quality of earnings reviews look at the stability and reliability of earnings as well.
  • This guide explains concepts that are covered with more context and with more thorough explanations in our free eBook Due Diligence: A Seller's Perspective. We recommend that guide as a starting point.

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What Is Financial Due Diligence:

Financial due diligence is one of the most important pieces of the due diligence puzzle.

The prospective buyer is likely using a significant amount of debt in order to finance this transaction and it is essential that the buyer confirm the strength of the target company's financials before moving forward.

Financial due diligence isn't as detailed as an audit. The review that the buyer's due diligence team will conduct here is primarily confirmatory in nature—making sure what you told them is the truth.

Sellers often fail to accurately represent their earnings power, not out of ill intent, but simply due to their lack of accounting expertise. It's important for financial statements to be presented in the proper accounting format. For businesses with meticulous accounting practices and no aggressive add-backs, this part of due diligence becomes about "checking boxes", and is relatively easy to navigate. However, if the accounting is not well-executed, it can become a time-consuming and troublesome endeavor.

Three key pieces of analysis normally make up the bulk of financial due diligence:

  • Quality of Earnings (normally called “Q of E”)
  • Net Debt (& debt-like items)
  • Net Working Capital.

This guide will focus on quality of earnings.

What is The Purpose Of A Quality Of Earnings Assessment?

Normally, in M&A deals, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) is used as a proxy for cash flow.

In effect, the buyers are willing to buy the business because this cash flow is valuable. Given this, our calculation for Adjusted EBITDA is important.

Adjusted EBITDA is EBITDA where we've added back or removed certain items in order to reflect a more accurate picture of the business's earnings.

An example of how EBITDA might be adjusted could be owner's compensation. Say the owner/founder of the business acts as a CEO and pays themself a salary of $800,000. When the new owners take over and the founder steps down as CEO, the new CEO won't make $800,000. Maybe the market-based wage for a lower-middle market CEO is $250,000. So, here we would adjust earnings back to reflect that the business is really generating an additional $550,000 in EBITDA, even though the accounting statements won't reflect this.

One of the main functions of a quality of earnings assessment is to scrutinize how EBITDA has been adjusted.

This is important because the purchase price will normally be defined as a multiple above adjusted EBITDA. So, if a business is sold for $17.5 million, and the adjusted EBITDA is $2.5 million, then we see the exit multiple as "seven" (17.5 / 2.5). In other words, the buyer is effectively paying the seller seven times earnings to acquire the company—so, it's important that we're using an accurate "adjustment" to EBITDA.

What Does Quality Of Earnings Scrutinize?

In the real world of M&A, an adjusted EBITDA calculation is something an M&A advisor should help you with because a portion of this quality of earnings due diligence will be dedicated to scrutinizing it and if it is found to be inaccurate, the purchase price will be adjusted.

Quality of earnings due diligence will go beyond scrutinizing adjusted EBITDA to assess the stability and reliability of earnings as well. There will also be more complexity with issues such as carve-outs, recent acquisitions, cost-saving initiatives, and when unexpected things happen (good or bad).

Because the purchase price is effectively a multiple above adjusted EBITDA, the prospective buyer will want to make sure the numbers are both accurately reflected and will be reliable moving forward. In our example above, we looked at a business that was sold for $17.5 million above $2.5 million in adjusted EBITDA. If after a quality of earnings assessment, that EBITDA came to $2 million the purchase price at a 7 multiple would be $14 million instead of $17.5 million—a difference that would almost certainly prompt the buyer to lower their initial offer by $3.5 million.

As an important note here, most business owners aren't accountants—and that's OK.

If this seems intimidating then remember that you will be working with a competent M&A advisor that knows what to expect from due diligence. Their experience will prevent problems like this from arising preemptively.

What Is Discovered Through Quality of Earnings?

Here are some things commonly found in quality of earnings reports during due diligence. Remember that during this due diligence process the final purchase agreement is being worked out along the way. Any findings here will merit further discussion and may impact the purchase price. This isn't an exhaustive list because theoretically, anything that impacts earnings could come up here.

However, these are some of the most common discoveries in quality of earnings reports:

  • Unjustifiable Add-Backs - Above we used the example of the difference between an owner's salary and a market-based wage for the job of CEO. This add-back makes logical sense. Some add-backs are easy to justify, and some aren't.
  • Incorrect Accounting Periods - Sometimes, revenue or expenses can mistakenly be accounted for in the wrong period. These errors are easily identified by diligent QofE teams.
  • Improper Accrual Accounting - In addition to accrual revenue or expenses being recorded in the wrong period, many times deferred revenues are not properly accounted for. If your business operates in a way where customers pay you before your business delivers its core service, and you don't account for this properly it will come up in a quality of earnings review.
  • Pro Forma Adjustments - Pro forma adjustments are used to display what your business's financials would look like in a hypothetical case. Sometimes businesses budget for "what if?" scenarios which could impact cost structures.

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