Quality of Earnings – the Driver of M&A Due Diligence
During an M&A transaction, the buyer will often hire a reputable accounting firm to perform a “Quality of Earnings” (QE) analysis. As the name suggests, a QE analysis aims to determine the quality of a target company’s profits (the money the company keeps from sales minus operating cost). Ultimately, the buyer wants to verify that the reported earnings are repeatable – consistently repeatable.
What earnings are repeatable?
Repeatable earnings primarily include earnings generated from on-going business operations that have a reasonable expectation of reoccurrence in future years. The potential acquirer wants to know that the business will continue to produce the same level of profits post acquisition. Sustainability in earnings from operations is the key value driver.
What earnings are not repeatable?
Non-repeatable earnings may include things like assets sales, changes in accounting procedures (especially revenue recognition), reductions in inventory, changes in working capital and other one-off events.
The QE Analysis
A quality of earnings analysis is different from an audit. While there are some similarities in tasks performed, like proof-of-cash, revenue recognition, verification of classifications and timing of financial accounts, etc., the QE analysis focuses more on the financial results from the company’s operations whereas an audit leans more into the balance sheet.
Also, a QE report will often consider operational risks like customer concentrations, dependencies on key people in management, depth of management team, pricing strategy, competitive threats, etc.
Because the analysis is typically performed by a consultant hired by the buyer, QE reports tend to present conservative views of future earnings. This is partly because:
- the buyer can use the QE report to negotiate the offering price down if the earnings are not as strongly portrayed by the third-party report. This is beneficial to the buyer. The consultant performing the QE analysis is incentivized to generate benefits for his or her client; and
- the consultant aims to get re-hired by the buyer in the future. Missing something in the QE report that is detrimental to the buyer post acquisition doesn’t get the consultant hired for the next project. It’s akin to the inspection report you get as a buyer for a house. It lists everything wrong with the house. Some things are instrumental. Some things you can ignore. An astute buyer knows the difference.
Knowing the important role a QE analysis plays in the due diligence and negotiation process, it can be advantageous for sellers to perform the analysis before going to market. As Terry Fick mentioned in our interview,
“The buyers are still going to do their own due diligence work. But if the seller has a reputable firm do QE in advance, then the seller has some ammunition to fight gray-area claims that come from the buyer’s QE later. Furthermore, if there’s a real issue, like a revenue recognition issue that needs to be addressed, the seller can address it early in the process rather than having a surprise in the third month of due diligence.”