This article is co-authored with Elliott Holland of Guardian Due Diligence, an expert in the acquisition of small and medium sized businesses.  He helps first-time buyers get through the challenging and nuanced financial due diligence & QoE process. His burning desire is to prevent you from losing a million dollars on a transaction. 

Elliott is a former mechanical engineer and Harvard MBA who has worked for the nation’s best business acquisition firms like The Watermill Group and Linx Partners and then started his own acquisition firm where he apprenticed under an industry veteran.  He started Guardian in 2018 to service the SMB and ETA communities.  

‍

The Basics of QoE when Buying a Business

When considering purchasing a business, it's important to ensure that you're getting your money's worth. That's where the Quality of Earnings (QoE) report comes in. This comprehensive report is a vital tool to have before making a purchase that could potentially cost you millions.

One of the most critical factors to consider when purchasing a small business is the quality of its earnings or EBITDA. The quality of earnings analyzes the stability, predictability, and sustainability of a company's EBITDA. Since businesses are valued based on multiples of EBITDA, this report becomes a huge part of the evaluation process for buyers, lenders, and investors.  The report is essential to make an informed decision about the financial viability of a small business.

This article aims to provide a comprehensive guide to evaluating the quality of earnings when buying a small business. We'll explore what a QoE report is, what it entails, and why it's crucial for anyone looking to acquire a business.

What is a Quality of Earnings Report?

At its core, a QoE report is a thorough examination of the ways in which a business generates cash. It's typically a 20-40 page document that provides validation for the company's cash flow. The report examines every aspect of the business, leaving no stone unturned.

As a business buyer, you can use the QoE to identify items that require further due diligence. Unlike a complete financial audit, the QoE report is more limited in scope and is usually sourced out to an independent third party during the due diligence process. It focuses more on financial-related due diligence procedures such as the earnings capability of the company, key business drivers, trends in profitability, and any identified areas of significant risk.

Factors to Consider

When evaluating the quality of earnings, several factors can help you determine the reliability and sustainability of the company's profits:

Revenue Recognition

Revenue recognition refers to how a company recognizes its income. It is essential to understand the company's revenue recognition policy to evaluate the quality of earnings. A company that recognizes revenue prematurely or manipulates its accounting practices may have an unsustainable revenue stream.

Questions to ask:

• How does the company recognize revenue?
• Does the  company report on a cash basis?  Accrual basis?  Hybrid?
• Does the company use any aggressive accounting practices?
• Are there any discrepancies between the reported cash flow and the actual cash flow?

Customer Base

The customer base is another critical factor to consider when evaluating the quality of earnings. A small business that relies heavily on a few key customers may face financial difficulties if those customers leave.

Questions to ask:

• Who are the company's largest customers, and what percentage of revenue do they contribute?
• How long have these customers been with the company?
• What is the customer retention rate? (churn)

Industry Trends

Understanding the industry trends is crucial to evaluate the quality of earnings. A small business operating in a declining industry may struggle to maintain its profits.

Questions to ask:

• What are the current trends in the industry?
• Is the industry growing, stable, or declining?
• What is the market share of the company compared to its competitors?

Management Quality

The quality of management can significantly impact a small business's earnings. A well-managed company is more likely to have sustainable earnings.

Questions to ask:

• What is the experience and track record of the management team?
• How long has the current management team been in place?
• What is the turnover rate for management positions?

Financial Statements

Analyzing the company's financial statements is an essential step in evaluating the quality of earnings. Financial statements provide critical information about the company's revenue, expenses, and cash flow.

Questions to ask:

• Are the financial statements audited by an independent third party?
• Are there any significant discrepancies between the financial statements and other financial records like taxes or bank statements?
• Are there any one-time or non-recurring expenses that may impact the quality of earnings?

‍

Strategies to Evaluate Quality of Earnings

Now that we have discussed the factors to consider when evaluating the quality of earnings, let's look at some strategies you can use to assess a company's financial stability.

Analyze Historical Financial Data

Analyzing the company's historical financial data can provide insights into the quality of earnings. Look for patterns in the revenue and expenses, and compare them to industry averages.

Use Ratio Analysis

Ratio analysis involves using financial ratios to evaluate the company's financial performance. Some common ratios used in ratio analysis include the debt-to-equity ratio, the current ratio, and the gross profit margin.

Consider Future Earnings Potential

It is essential to consider the future earnings potential of the small business before making a purchase. Look at the company's growth potential, competitive advantage, and any upcoming changes in the industry. Keep in mind that you’re only buying future earnings.

Seek Professional Advice

Seeking professional advice from an accounting firm or due diligence firm that focuses on deals your size can help you evaluate the quality of earnings. These professionals have experience in evaluating small businesses and can provide valuable insights.  Be cautious relying on business brokers and traditional financial advisors who are not experts in buying small businesses.

‍

Scope of a Quality of Earnings Report

The scope of each QoE report will be unique depending upon the nature of the transaction and the size of the company or business operations being acquired, as well as the desired level of comfort during the due diligence process. A financial due diligence process would typically involve a review of the following areas:

• Historical financial results
• Current financial position
• Working capital requirements
• Risks and opportunities
• EBITDA add-backs
• Taxation implications
• Recent adjustments in the business that will impact future cash flow

As a business owner, you can expect the QoE Report to focus more on financial-related due diligence procedures such as the earnings capability of the company, key business drivers, trends in profitability, and any identified areas of significant risk.

common pitfalls you see people running into when analyzing a QoE report

Common Pitfalls Analyzing a QoE Report

It’s mission critical that you understand the QoE report you get for your target acquisition.  The report can show large changes in EBITDA which will have changed the company valuation all together.  For non-financial buyers it can be daunting to understand this somewhat dense report but here are some pitfalls to avoid:

• Just looking for EBITDA in the report without looking at trends or customer concentration or any other area of analysis
• Only looking back 12-18 months.  Be sure the scope of your project covers at least three years of analysis
• Not asking your provider questions in areas that you don’t understand.  It’s your report.  Be sure your provider answers any questions on areas you don’t fully understand.

Preparing for a Quality of Earnings Report

The information required to complete a QoE Report depends on the agreed-upon scope as well as the reporting capabilities of the target company. Typically, you’d need:

• Historical financial data for the last three-five years, (preferably audited or reviewed), including the monthly and trial balance detail.
• Current financial data such as year-to-date management accounts
• Forecast financial information (next 12-18 months)
• Copies of any loan or debt agreements
• Federal, state, and local tax returns for the last three-five years

‍

Conclusion

A Quality of Earnings report can save buyers millions of dollars by identifying any financial irregularities that the seller might have missed or not disclosed. These irregularities can significantly impact the company’s future ability to earn, and without a QoE report, buyers might not be aware of them. With the help of a QoE report, buyers can negotiate a more reasonable price or avoid purchasing a non-cash-flowing business altogether.

‍

‍

‍

Elliott Holland of Guardian Due Diligence

Elliott Holland is an expert in the acquisition of small and medium sized businesses.  He helps first-time buyers get through the challenging and nuanced financial due diligence & QoE process. His burning desire is to prevent you from losing a million dollars on a transaction.  Elliott is a former mechanical engineer and Harvard MBA who has worked for the nation’s best business acquisition firms like The Watermill Group and Linx Partners and then started his own acquisition firm where he apprenticed under an industry veteran.  He started Guardian in 2018 to service the SMB and ETA communities.  

‍