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Quality of Earnings Report

A Quality of Earnings (QofE) report is a financial due diligence document, prepared independently in connection with an anticipated merger, acquisition or divestiture. Among other things, a QofE highlights the acquisition target’s historical financial performance, potential transaction risks and opportunities, and the sustainability of earnings.

QofE reports are intended to cut through bias and are generally performed by an independent, third-party accounting firm with a team that specializes in QofE analyses. A QofE report is often required by lenders or other stakeholders involved in the M&A transaction. Additionally, most financial due diligence engagements will assist the buyer or seller with other complex deal issues, such as estimating the normalized level of working capital needed to operate the business, net debt considerations, go-forward considerations and other financial matters relating to the transaction.

Why Obtain a QofE?

A carefully thought out diligence plan is critical to executing a successful M&A transaction. Successful M&A transactions are notoriously hard to execute, many acquisitions fail due to buyer bias, incomplete or erroneous information or a poorly executed diligence plan. Buyers and sellers generally do not come to the table with equal information. A buy-side QofE helps minimize the seller’s informational advantage over the buyer in regards to financial performance, accounting policy, and operations. Even strong financials that are compliant with GAAP can be manipulated and hide material inaccuracies or inconsistencies. A well-executed QofE helps level any financial information differences between the buyer and seller. Similarly, a sell-side QofE provides transparency and allows a seller more time and information to understand complex deal structures and identifying the best successor or go-forward partner.

Obtaining a Quality of Earnings analysis is comparable to obtaining a home inspection prior to closing on a house. After submitting an offer and going under contract, most buyers will seek a home inspection to ensure there are no water leaks, roof damage, foundational issues, electric system problems, etc. Similarly, buyers of a business will want to gain confidence in the financial information, understand key reporting metrics and recognize any risks associated with the change of control prior to closing.

How Is It Different From an Audit?

An audit primarily focuses on evaluating a company’s financial reporting and compliance with accounting principles, using the balance sheet as the main source of the point-in-time review. An audit is not designed to assess the sustainability of earnings or the reliability of earnings on a go-forward basis. A QofE gives a broader financial and operational view of the business, typically focusing on EBITDA and highlighting key financial metrics and trends in the business. A quality of earnings will delve into gross margin and performance metrics, sales and customer analyses, and other relevant data to provide insights into the underlying economic performance of the business and net working capital trends. While audits are focused on annual results, a QofE will emphasize monthly performance as buyers (and lenders) are particularly interested in the trailing twelve month results. Further, a QofE is often used as the foundation to illustrate and project go-forward earnings post-transaction. A QofE may also contain pro-forma considerations of interest to a buyer.

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