What Is Quality of Earnings?

A Quality of Earnings (“QoE”) study is performed during the due diligence phase of a proposed transaction. During this analysis, a qualified team of professionals evaluate the acquisition target’s financial statements in order to assess normalized earnings, areas for improvement, the integrity of seller representations, and exploitable post-acquisition synergies. Specifically, a QoE study seeks to translate these assessments into cash flow, where the greater and more sustainable the level of cash flow, the higher the quality of earnings.

Unlike an audit, which seeks to measure compliance with applicable guidelines and accounting conventions, a QoE study seeks to determine sustainable economic income. As such, the objectives of a QoE study (namely, assessing cash flows and the risks of achieving/maintaining/growing those cash flows) draw heavily on the skill sets of forensic accountants and business appraisers.

What It Looks Like

While a QoE study will be tailored to the transaction participants, the general timeline below will be followed:

  1. The scope of engagement will be determined by mutual agreement between the buyer and the firm (“analyst”) undertaking the QoE study. The scope of engagement is critical to answering the cost vs. benefit question. If the scope is too limited, the QoE study may not yield sufficiently helpful findings; however, if the scope is too broad, the QoE study may take too long, cost too much, and lose focus on the key objectives of assessing sustainable cash flow.
  2. The analyst will request the due diligence file, which should include the seller’s financial statements and other representations (such as agreements in place, customer and vendor concentrations, factors positively and negatively impacting growth, nonrecurring recent financial activity, and related-party transactions).
  3. After reviewing the due diligence file, the analyst will request additional information to cure any deficiencies in the documentation necessary for the QoE study.
  4. A combination of the following financial analyses will then be undertaken:
    1. Historical earnings will be normalized to remove nonoperating and nonrecurring revenue and expense items.
    2. Adjustments will be made to accounting conventions and reporting metrics to ensure that comparisons of historical periods and assessments of post-acquisition operations are not misleading.
    3. The seller’s representations will be tested as to:
      1. The sustainability, concentration, and overall riskiness of ongoing revenues, including the extent to which post-acquisition revenues may be dependent upon key personnel, proprietary processes, and other variables that may not effectively transfer during the acquisition.
      2. The variable relationship between cost of goods sold and revenues, including the sensitivity of costs to post-acquisition revenues.
      3. The level of general and administrative expenses, including reasonable officer compensation, the fair market terms of leases and other agreements, and the impact of related-party transactions.
      4. The realizable value of assets (such as inventory and receivables) and the true cost (and meaningful disclosure) of liabilities.
      5. The acquisition target’s solvency and working capital needs.
      6. The reasonableness of assumptions and variables incorporated into management projections and the extent to which those projections can be supported by historical normalized earnings.
    4. The various tests and adjustments described above will lead to an assessment of sustainable cash flow, which will represent a high quality of earnings if materially positive and sustainable, a low quality of earnings if minimal, negative, or not sustainable, or some point within that range.
  5. During the QoE analysis, the analyst will provide periodic updates and, if within the scope of engagement, the analyst will memorialize findings in a report. Most QoE studies are finalized and presented in a report, although the length and comprehensiveness of the report will depend in large part on the scope of engagement.
  6. Using the QoE study’s assessment of sustainable cash flow and identification of post-acquisition value drivers, the buyer will be better situated to negotiate favorable terms (or at least mitigate unreasonable positions) with the seller.

Who It Benefits

While our discussion has focused on buyer-commissioned QoE studies, it bears noting that the seller may also benefit from commissioning a QoE study since the analysis results that would allow a buyer to negotiate reductions in the transaction price could also allow a seller to negotiate an increase in the transaction price or otherwise expedite the closing.

While a buyer will typically be attracted to various synergies in a transaction, they will not usually be willing to pay for the value that they “bring to the table”. However, if a seller undertakes a QoE study, the analyst may find synergies and streams of sustainable cash flows not already reflected or considered in the buyer’s letter of intent (“LOI”). Further, a seller-commissioned QoE study will allow the seller to be more adept and adroit at responding to the buyer’s questions and arguments, which could speed up the due diligence process. As such, a seller-commissioned QoE study may also prove beneficial.

The Logistics

So, do you need a QoE study, when should it be initiated, how long will it take, and how much will it cost?

The answer is, “it depends”.

If a QoE study is required in order to secure financing, then there is no choice. However, even if no such requirement exists, a QoE study can still add value for the reasons discussed herein.

Ideally, from the analyst’s perspective, a QoE study should be initiated sooner rather than later in the due diligence process. However, as a practical matter, QoE studies are often not initiated until further along in the due diligence process, after financing is in place or other aspects of the deal have been settled, since foundational work may be required in order to necessitate the QoE study.

Assuming that information is exchanged and provided within reasonable proximity to when it is requested, the QoE study should be completable within the due diligence time frame proposed in the LOI (usually 30 to 90 days) unless extenuating circumstances cause a delay.

The cost of the QoE study will depend upon variables such as the scope of work, the quality, quantity, and comprehensiveness of financial records, and the time frame allowed for the analysis. While a QoE study may cost up to the high five figures depending upon the variables discussed herein, its cost will usually be in the range of $10,000 to $50,000. Since the cost will not be contingent upon the QoE study’s findings or the deal going through, such understanding bears consideration when assessing whether and when to initiate a QoE study.

For more information regarding QoE studies and how they can be beneficial to the due diligence process, please contact us.