February 21, 2022

A Quality of Earnings (QoE) report is often compared to a home inspection, and it’s an analogy that resonates for many reasons. An independent party is hired to complete an unbiased analysis, it is typically completed in advance of a significant transaction for the buyer and seller, and the exact contents of the inspection are not always the same. Certain homes require special attention in areas that other homes do not, and the same goes when evaluating businesses.

The contents of a QoE report are as wide and as varied as the companies they are covering then. Each report is tailored to meet the needs of the requesting party, as well as its known and anticipated users. Each business operates in a different market, intersects differently with other market participants, and has unique risks and opportunities. But, while this dynamic makes QoE reports diverse, there do tend to be some common focal points for businesses in the middle market. This article will cover those common sections.

Adjustments and Normalized Earnings

Identifying any adjustments that are necessary to reported earnings is a core area of study in QoE reports.

The purpose of this analysis is to paint a picture of a normalized revenue volume and expense load for the company going forward, which will help to set a baseline. It is important to understand any one-time or non-recurring revenues and/or costs so they can be considered in developing expectations for operating performance in subsequent years, after the close of the deal.

In our observation, the following tend to be common adjustments:

  • Salary and benefits costs for executives or other employees that won’t be retained
  • Deal-related costs
  • Significant severance or recruiting costs
  • In the past few years,
    • Costs specific to COVID protective measures
    • Pandemic relief revenue
    • Rent abatement
  • And many others, depending on the industry or company structure.

It is important to remember that the definition of unusual or non-recurring will be determined on a case-by-case basis. Severance or recruiting costs could be a consistent and standard cost for some companies, and an unusual or infrequent cost for others.

Trend Analysis

The first two sections, identifying adjustments and recognizing trends, are a critical part of understanding the quality of a company’s earnings streams. Are they sustainable and lasting? Are any components of actual earnings unique and unlikely to happen again? Are actual earnings highly sustainable and therefore of higher quality than those that are fleeting?

The purpose of this analysis is to observe trends over the period under review in the company’s performance as measured by total revenues, gross margin, and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This analysis is typically completed over a period of two or three years, in addition to a “trailing-twelve month” timeframe to help analyze performance during the current period.

The length of time covered by this analysis is helpful to understanding if current performance is an anomaly or if it represents a prolonged trend, and therefore is considered sustainable. In the last two years, certain businesses have thrived through the pandemic. Trend analysis seeks to understand if that improved performance is an anomaly or if it will continue as conditions normalize. Analysis over multiple years also sheds light on the relative seasonality of revenue volume and/or profitability within a single business cycle and over time.

This section also tends to include some details from the income statement. Revenues are analyzed here to not only observe trends, but also to better understand if any discounts and allowances are common for the business and the drivers for that activity. Categories of cost – both cost of goods sold and selling, general and administrative costs – are also explained and analyzed for trends. This helps explain what cost centers are driving spending for the business.

Customer Analysis

A deeper understanding of customers is also a valuable and relevant part of the QoE report. One goal of this analysis is to better understand the sources of revenue for the company, both in terms of the types of products and services sold, as well as which customers are buying. This will be unique to each business.

Some companies will have multiple revenue streams that sell to different customer groups (e.g., a consumer products company that sells to retail channels, direct-to-consumer, and/or e-commerce), while others will have a more simplified revenue structure (e.g., a software-as-a-service company or a construction general contractor). Some businesses will sell to a concentrated group of major customers (e.g., a retailer utilizing an online channel like Amazon.com), while others will have relatively diverse and similar sales to a broad array of customers (i.e., an online subscription service). Each of these scenarios brings distinct risks and opportunities that need to be understood.

The key questions addressed by the customer analysis are:

  • The stability of sales to these customers over the period;
  • The existence of concentrations with individual customers – the risk being, how would the company replace those sales if the customer terminated the relationship, and;
  • The relative trend toward a more diverse or more concentrated customer base throughout the period.

Working Capital Trends

Like the work done in the adjustments analysis, there are certain components of working capital that can be unique or unusual and may need to be adjusted.

The purpose of this analysis is to determine the amount of working capital needed to (a) generate the profits produced by the business historically and through the deal, and (b) to meet the company’s current obligations in a timely manner. The ultimate goal is to make sure enough working capital is left in the business so that operations are not disrupted as a result of the deal.

Common adjustments to working capital we have observed are as follows:

  • Deals are often executed on a cash-free, debt-free basis, which means that the seller will keep the cash in its possession, but they will also be responsible to repay the debt as well. In practice, most debt instruments are repaid as a part of a deal closing. For these reasons, analysis in this area typically excludes cash and debt items.
  • In the past few years, loans acquired through the Paycheck Protection Program, and their related accrued interest, need to be adjusted.

Once major components of working capital are identified, they are further analyzed to determine if they are of good quality. For example, accounts receivable are reviewed to determine if the company is being diligent about collections. Trends on the relative age of receivables, the number of days of sales outstanding in receivables, and the existence and magnitude of an allowance for doubtful accounts are common. If inventory is significant, this will also receive further analysis to include the aging and turnover of inventory to address the risk of obsolescence. Businesses that receive customer advances or have significant deferred revenue might also choose to zoom in on those liability balances. Other current assets and liabilities would also be analyzed to the extent they are significant.

Other Unique Elements

The pieces described above tend to be discussed in any QoE analysis. Beyond those, there are other areas that can be included in this analysis and tend to be circumstantial or industry specific. A few examples are as follows:

Proof of Cash

A proof of cash has many uses, one of which is a measure of how a company’s cash receipts and disbursements track with its recognition of revenues and expenses.

The amount of cash deposited in the bank in a month’s time rarely aligns perfectly with the amount of revenue recognized by the company due to changes in receivable balances, pass-through items like sales tax or freight, and advance deposit payments, to name a few examples. The same is true of cash disbursements and expenses.

A proof of cash gives comfort that the transactions hitting a company’s bank accounts are being included in its accounting records, and vice versa. This is a valuable addition to the QoE process, especially in the case that a company hasn’t historically been audited or reviewed by an independent CPA.

State and Local Tax Overview

Taxes at the state and local level are varied and complicated. Companies that do business in multiple states have an increased risk for unknown liabilities if they are not handling state and local tax compliance with great care and attention. An overview of the company’s state and local tax exposure is a critical part of this due diligence effort and may be included in a QoE report as well.

Revenue Recognition

Recently, the accounting rules related to the timing and conditions of revenue recognition have changed. Some businesses have made this conversion, while others have not. Particularly for those businesses that have not converted to the new guidance, an analysis of any major differences between the two sets of rules is a valuable addition to this analysis.

In Conclusion

The previous section really shines a light on a theme of QoE work and brings us back to the notion that, like a home inspection, certain businesses require special attention in areas that other businesses do not. Not every QoE report will have all of the elements listed above. And even when major components are included in the analysis, the detailed contents will touch on different elements, different risks, and different successes. Each company has its own story and the QoE process is one way that this unique story can be told.

If you’d like to learn more about QoE reports, or you’d like to schedule one for a business you’re buying or selling, send us an email. You can also read more about QoE reports in our Frequently Asked Questions article.

© Clark Nuber PS, 2022. All Rights Reserved.

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.