Quality of Earnings Report
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Why a Quality of Earnings Report Matters
A few years ago, one of my accounting clients approached me about selling his business. He had lots of questions, so we met for lunch to discuss. We talked about why he wanted to sell, the potential worth of his business, and whether he had any buyers in mind.
One of his main questions was what valuation his company would receive on the market and how he could prepare to maximize this value. I told him he should consider a Quality of Earnings Report.
His business was in good shape, but he needed a clearer awareness of how the market would perceive his business. A few metrics covered within a Q of E Report are sustainability, customer concentration, and future potential.
A Quality of Earnings Report is similar to a Financial Audit but without as much detail or cost. In the case described above, the entrepreneur requested the report – but in other situations, potential buyers have requested it. Sometimes this report can help bridge buyer-seller valuation gaps, while other times it is completed by an entrepreneur to prioritize accounting fixes and tweaks.
A Quality of Earnings Report can be incredibly valuable for your business. Check back next Thursday to learn more.
What Is a Quality of Earnings Report?
An analogy I like to use when it comes to Quality of Earnings is one-hit wonders. How can a band create an iconic song, but not have the ability to re-create that magic? And what about some of the best bands – The Beatles, Rolling Stones, Led Zeppelin – why were they able to produce so much incredible music over the course of multiple decades?
Similar to one-hit wonders, some companies perform well for a short time before failing. Oftentimes, these companies are set up for failure by the nature of their earnings – for example, one successful product or dependence upon one customer or supplier.
To put it simply, all earnings are not created equal. With a QoE Report, the quality of your earnings are analyzed based on the following: Consistent, predictable, repeatable Realization of risk of assets Maintenance of capital Ability to satisfy obligations Track record of solid cash flow Working capital & capital needs A Quality of Earnings report can be used as a tool for operational improvement and provide an unbiased analysis of how the market interprets a company’s earnings.
Positive Business Qualities To Increase Valuation
Valuing businesses is as much of an art as a mathematical equation. There are a number of clear rights and wrongs with business valuation, but there are also many areas where the experience of top valuation firms help when the numbers are not crystal clear.
For my next post on Quality of Earnings, I will dive into a few positive qualities of businesses that increase their value when sold.
Three favorable characteristics of earnings quality:
Truthful accounting statements. The degree to which the accounting policies employed reflect the economic reality of a company's transactions.
Stability. Year-over-year revenue and profit stability, especially the last 3 years. This refers also to the degree to which income statement components are recurring in nature.
Risk/Accurate Projections. The degree of realism used to develop estimates of current and future conditions. While businesses are valued primarily on past earnings, industry projections and industry risk are certainly factors.
Within the full PDF of this series (to be posted mid-August), I will dive into a few additional positive characteristics, including characteristics of employee salaries.
What To Watch Out For
Now that we’ve hit the positive company aspects in Quality of Earnings Reports – time for the things to watch out for!
Issue 1: Bad estimates of assets or liabilities. Companies like Enron and Groupon became infamous for claiming inflated revenues, while some companies have been accused of minimizing liabilities. It is critical that values are estimated reasonably, although sometimes easier said than done.
Issue 2: Improper accrual accounting. Sometimes businesses with deferred revenue take it too early causing the earnings to be higher than accounting rules allow. Same with expenses. Cut-off test work is performed to decide whether all transactions are recorded in the correct period.
Issue 3: Improper addbacks. Usually sellers want to make their earnings as strong as possible. Some addbacks are logical, such as owner salaries larger than what is needed to pay a professional manager. But some are not as defensible. When it comes to selling time, the mere presence of some addbacks can result in breaches of trust. Mistrust can be more damaging than the add-back value when it’s offer time!
SDE vs. EBITDA
Why are some companies valued on a multiple of SDE (Seller’s Discretionary Earnings) and some on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)? Businesses are valued on different metrics because the nature of acquisitions changes with the size of business, type of business, type of buyer, and many other factors.
SDE is typically used with smaller businesses with yearly earnings below $1 mil mainly due to the type of buyer (owner-operator). At this level, buyers are typically owneroperators concerned with total compensation they will net while running the business.
For businesses with yearly earnings over $1 million, EBITDA is used because larger firms or buyers are typically buying a business with a leadership team in place, or one that will require new leadership. Thus, it makes sense to adjust yearly earnings by removing interest, taxes, depreciation, and amortization, but not the owner's total compensation.
Differentiating SDE vs. EBITDA is a crucial component to a Quality of Earnings Report because it allows the seller to view their business from the eyes of potential buyers.
Identifying your financial needs and ensuring legal and financial readiness are key steps in preparing for a business transaction. Whether it's the final chapter or a stepping stone to your next venture, being prepared makes all the difference.
For expert assistance in preparing a Quality of Earnings report, contact us at info@exitadvisors.com.
