Deep Dive into Financial Statements with a Quality of Earnings Analysis

Jason Pagan, CPA

A Quality of Earnings (QoE) analysis is a deep dive into the financial statements to understand where the business generates value. The Quality of Earnings is not an audit but rather a detailed financial analysis, and the two are not mutually exclusive but complementary. 

An audit is balance sheet focused, whereas the Quality of Earnings is concentrated on the income statement, emphasizing a company’s true ongoing earnings and cash flow potential, often measured as EBITDA. Both focus on the importance of getting the accounting correct, but the QoE’s primary goal is to allow a buyer to gain a detailed understanding of the underlying earnings power of the company. 

An audit is historical by definition, while the Quality of Earnings starts with historical results but “normalizes” reported EBITDA for items that are non-recurring or non-operating to provide a pro forma presentation of EBITDA and what it will look like on a go-forward basis. At this stage, a company’s pro forma EBITDA can then be compared consistently to the projections of future EBITDA generated by the company.

Since investment bankers, private equity professionals, and M&A practitioners consider EBITDA a reasonable proxy for operating cash flow, the “Adjusted EBITDA” or normalized amount is the central figure in the M&A community.

The Fundamentals of QoE

The QoE report is a tailored consulting product with no standards body dictating minimum requirements. Industry-standard methodologies exist, and the income statement, balance sheet, and shareholder’s equity section are all analyzed for their impact on EBITDA and working capital

QoE does not involve compliance with GAAS, and the resulting pro forma EBITDA is not a measurement prescribed in GAAP. QoE work is performed under the American Institute of Certified Public Accountants (“AICPA”) consulting standards.

Disclosures

• Discussion of key deal issues
• Quality of earnings with explanations and exhibits supporting adjustments
• Cash-free/debt-free working capital adjusted for due diligence items
• Income statement and balance sheet schedules, trends, and key performance indicators
• Detail of revenue recognition and customer/product revenue and margin analysis
• Analysis of cost of sales, operating expenses, and compensation
• Proof of cash (depending on deal size and whether previously audited)

Level of testing and third-party confirmations were not performed in Quality of Earnings analysis. The scope will vary as agreed upon with the client—analytical in nature using source documents with specific calculations involving transaction evidence.

The Quality of Earnings analysis may identify issues such as:

• Identify supporting documentation: Identify support documents for adjustments to cashflow.  Identify the true cashflow generating ability of the business is key to understanding the debt service capacity and purchase price of the potential transaction
• Changes with key customers: Identify key customers and any concentration and a better understanding of the relationship with these customers assists concerned parties in better understanding theses relationships and any mitigating factors
• Issues related to inventory valuation: For inventory based business models, understanding the accounting, inventory turnover, and understanding whether obsolete inventory is present is important to gross margin and the balance sheet in the transaction particularly for purchasers who typically assume inventory in asset sales or within purchase or working capital
• Significant changes in reserves between periods: Reserve accounts such as bad debt write policies are typically develpped by management and estimates are used. Analyzing these estimates for reasonableness is relevant to understanding the accounting and business model of the company
• Where amounts are recorded in the financial statement: One of the core elements of the quality of earnings is identifying personal or discretionary, non-recurring expenses in the profit loss, where we identify these identifty and obtain supporting documentation to arrive at adjusted EBITDA cashflow.
• Inaccurate capitalization policies for fixed assets: Identify the dollar threshold where a company chooses to expenses a piece of equipment or capitalize equipment over many periods can influence the reported EBITDA of the firm. Understanding the policies and adjusting for the true economic impact of the necessary expenditures to cash flow is important to all parties involved in a proposed transaction. 
• Inconsistent application or changes in accounting policies: Identify any changes in accounting method from period to period can cause distortion in financial trends while identifying these changes and normalizing them for comparability can provide buyers better insight into the long term prospects of the company.
• After the QoE process is completed, users of the financial statements have greater visibility into the quality of the historical financial statements and a clearer picture of the run rate of EBITDA on a go-forward basis.

Benefits of Quality of Earnings for SBA Lenders

Perhaps the most significant benefit from a well-structured Quality of Earnings engagement is assessing the quality of the financial statement projections. The financial statement projections are prepared by management, who may be a shareholder or employed directly under the shareholder, which could impair independence. Management typically understands that the projections will impact the transaction value; many managers have never prepared financial statement projections that extend beyond the following year’s budget.

Lenders must have confidence that a company’s earnings and cash flows are sufficient to service its debt. The reports provide greater comfort to the lender in setting the amount of exposure they are willing to base on the company’s cash flows. The reports help the company negotiate the interest rate and the loan amount from the lenders. The information can also assist in negotiating covenants and determining the need for or when shareholder guarantees can be released.

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