M&A Insights

Quality of Earnings Overview

By: Trent Barnes

Numerous complexities arise throughout the M&A process. Assessing the quality of an acquisition target’s earnings is one such complexity. As financial results are a significant driver of a company’s valuation, determining the quality of the results is an important step in the M&A process.

Earnings quality is evaluated by a financial professional through a quality of earnings assessment (“QoE”). It is typical for a buyer to require a QoE during the M&A process. However, sell-side QoEs have become increasingly popular due to the valuable insight they provide. Before we discuss the benefits of a buy-side and sell-side QoE, lets first discuss the term earnings quality.

What is Earnings Quality?

Earnings quality is difficult to define given the multiple factors that drive the analysis and overall subjectivity involved. Ultimately, a buyer wants to understand how faithfully the reported earnings reflect past transactions, and if the earnings are predictive of future performance. Higher quality earnings are those that are regularly recurring, non-judgmental, and reported on an accrual basis with consistently applied accounting policies. The below graphic summarizes just a few of the factors that impact earnings quality.

It is important to note that lower earnings quality does not equate to poor financial performance. Large non-recurring transactions and transactions that require significant accounting estimates both negatively impact earnings quality, despite being perfectly legitimate and profitable transactions. This is a frequent point of confusion for sellers going through their first QoE. Given the complexities and subjectivity around earnings quality, a sell-side QoE is a valuable tool for companies preparing for a sale.

Sell-Side QoEs

Sell-Side QoEs are typically performed during the preparation phase of the M&A process. Executing a sell-side QoE early in the M&A process provides multiple benefits to the seller, including:

• EBITDA Adjustment Identification: Non-recurring and non-operating expenses are often identified through sell-side QoEs. Examples include owner’s personal expenses, market rent adjustments, and one-time legal fees. As these expenses will not reoccur after the transaction, they are added back as an adjustment to EBITDA to provide a more accurate view of the Company’s go-forward operations. EBITDA adjustments can result in significant value for the seller, as transactions are typically priced on a multiple of adjusted EBITDA. In fact, EBITDA adjustments alone can justify the cost of a sell-side QoE, as a $100,000 EBITDA adjustment could result in a $500,000 purchase price increase, assuming a 5x adjusted EBITDA multiple.
• Due Diligence Preparation: Sell-Side QoEs help a seller prepare for the due diligence phase of the M&A process. Significant trends, transactions, accounting policies, variances, and potential errors may be identified through a sell-side QoE. As the assessment is performed before the marketing phase, a seller has time to address the findings before any potential buyers ever see the financials. This preparation reduces the workload required during the due diligence phase as key documents have been collected and management is ready to discuss significant transactions and trends with potential buyers.
• Optionality: Identifying and resolving issues early in the M&A process is crucial. Because a sell-side QoE occurs before a company is marketed to potential buyers, a seller can "button-up" the financials while it holds the negotiation leverage. However, the population of potential buyers will steadily decrease throughout the marketing and due diligence phases. As a result, issues uncovered by a buyer’s due diligence may provide that buyer with leverage it can use to renegotiate the purchase price. The buyer’s knowledge that it is one of the few remaining parties only increases this leverage. By investing in a sell-side QoE on the front-end, a seller may avoid a painful purchase price haircut caused by unforeseen issues uncovered by a buy-side QoE.  

Buy-Side QoEs

A buy-side QoE is a crucial piece of a buyer’s due diligence given the informational asymmetry that exists between a buyer and a seller. Benefits of a buy-Side QoE to a buyer include:

• Financial Analysis Deep-Dive: Even if a seller has audited financials, a buyer will want to understand the quality of the seller’s earnings. A buyer does not want to pay a premium for non-recurring transactions or one-time gains. Further, a buy-side QoE can help a buyer assess the reasonableness of management’s projections and determine if the seller has underinvested in the business to artificially boost short-term financial performance.
• Operational Strategy: The financial deep dive performed during a buy-side QoE enables a buyer to assess its overall strategic fit with the acquisition target. A buyer can review key drivers of the company’s top and bottom lines, providing valuable insight into synergies and opportunities that may arise from the acquisition.
• Red Flag Identification:  As mentioned above, a QoE may uncover accounting inconsistencies or errors. While these findings can often be explained and corrected, the findings themselves may raise red flags regarding financial reporting controls, personnel, and management oversight. If enough red flags are raised, a buyer may decide that it is best to walk away from the transaction.

As we have discussed, QoEs are a valuable part of the M&A process, providing benefits to both parties. When contemplating a transaction, it is important that you bring on a trusted M&A advisor that can help you navigate the various complexities of the M&A process.

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