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Understanding Quality of Earnings When Selling a Business

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Key Takeaways

  • Unlike a traditional audit, which focuses on compliance with accounting standards, a quality of earnings report digs deeper into the sustainability and reliability of earnings.
  • Understanding your financial health before going to market allows you to refine your accounting and prepare for potential questions during the transaction.
  • A third-party advisor is essential to the process, helping you interpret findings in a way that enhances the value of your operations.

Whether you know it or not, you have been preparing for a sale for years. Now is the time to start collecting the materials to explain your results and tell your story.

What is a quality of earnings report?

A Quality of Earnings (QofE) report is a comprehensive analysis of a company’s financial health. It analyzes precisely how your business accumulates revenue.

This report is invaluable for business owners during a sale because it provides a clear picture of the company's true earning power — stripped of any one-time gains, accounting anomalies, or non-recurring income.

Unlike a traditional audit, which focuses on compliance with accounting standards, a QofE digs deeper into the sustainability and reliability of earnings.

Why isn’t an audit enough?

QofE is often confused with an audit. But a QofE does not involve attesting to financials or verifying underlying documents — there is no formal attestation involved. Rather, it focuses on economic earnings.

An audit is not sufficient for due diligence because:

  • Audits focus on verifying if financials are GAAP-compliant, while due diligence provides insight into revenue and cost drivers, operational efficiency, cash flow stability, customer and supplier relationships, and potential risk factors.
  • Audits focus on material misstatements that could affect the financials. Potential liabilities that fall below these thresholds could be missed even if they are significant in the context of a transaction.
  • Audits will not always call attention to one-time events that may impact your financial results.

How does a quality of earnings report help during a transaction?

Understanding your value prior to going to market gives you bargaining power, as you’ll feel more confident in the state of your business. It can also keep the deal on track by identifying pitfalls well in advance.

Conducting a sell-side QofE helps you:

  • Gain insight into how buyers will assess your earnings and key financial areas.
  • Demonstrate to potential buyers that you’re committed to selling and have taken steps to make your company sale-ready.
  • Address and resolve past financial issues to potentially enhance your company’s value.
  • Ensure all necessary add-backs and adjustments are properly documented.
  • Tackle challenging questions and concerns before buyer discussions begin.
  • Prepare documents in advance, reducing pressure on your team during the sale process.
  • Depending on the results, waiting to sell for another year after the QofE is completed could return significant value, as management would have time to focus on improving key performance indicators and value drivers.

What does the quality of earnings process look like?

The process for a QofE report begins when you are considering selling your company or a segment of your company. Typically, the timeframe is within six to 12 months after you decide to sell.

After you’ve selected a third-party advisor to conduct the QofE report, you can expect the following:

Introductory Consultation

The initial meeting with the Quality of Earnings (QofE) team is designed to discuss the objectives of the engagement, provide an overview of your business operations, and share key financial information.

Information Gathering

The QofE team will gather all relevant data from your business, including financial statements, tax returns, and customer contracts. 

It’s essential to appoint a key individual within your organization to communicate with the QofE team throughout the engagement. This person will assist with data requests and ensure confidentiality throughout the process.

Initial Analysis

The QofE advisors will begin analyzing the collected data to identify key areas of focus. Preliminary findings, questions, or clarifications will be communicated to your internal team.

Deep Dive Analysis

Upon collecting all necessary data and clarifying goals, the QofE team will conduct a detailed analysis of your financial data to assess the quality of your earnings. This stage includes:

  • A thorough examination of revenue, expenses, and key financial metrics.
  • Identification of one-time items, unusual trends, or adjustments.
  • Requests for additional data or explanations as needed.

Discussion of Findings

An initial QofE report will outline the findings of the engagement, including any adjustments or key issues. A meeting will be scheduled with your advisors to discuss the report, gather your feedback, and address any questions.

Final Report

After incorporating your feedback and clarifications, the advisors will finalize the report.

Follow Up

Based on the engagement results and your organizational goals, the QofE advisors may provide ongoing support or schedule a follow-up review once adjustments and improvements have been implemented.

As the QofE process proceeds, stay involved. This allows you to better understand not only the due diligence process but also deal options, value points, and the final deliverable.

What information is included in a quality of earnings report?

The quality of earnings report highlights the key aspects of your business, including:

  • Normalized level of EBITDA and the addbacks to bridge from reported EBITDA to adjusted EBITDA
  • Fluctuations in annual and monthly financial information
  • Revenue and gross margin by product, customer, or distribution segments
  • Operating expenses and employee analysis
  • Key balance sheet highlights
  • Normalized levels of working capital needed to operate the business

It also enables leadership to consider:

  • Have we had any significant one-time events, infused significant growth, or added process improvement capital that affected our financial performance?
  • Have we prudently managed our working capital and cash flow?
  • Do we have discretionary expenses affecting EBITDA?
  • How do our compensation packages compare to the market?
  • Have we reasonably forecasted our growth?
  • Have we outgrown our current technologies?
  • What is the outlook for our organization?
Although primarily focused on financials, the QofE report may also explore your IT landscape, finance team composition, accounting processes, and other operational details to assess the overall quality and reliability of financial data.

How to Move Forward

Selling your business is a major milestone. A QofE gives you the information you need to navigate the process strategically.

Our team of Certified Merger and Acquisition Advisors and Certified Public Accountants dedicate 100% of their time to due diligence and quality of earnings projects. Wherever you are in the transaction process — we can help.

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About the Author(s)

Aditi Udas

Aditi Udas

Manager
Aditi focuses on analyzing and making sense of the financial information. She brings value by providing insights on financial and operational aspects of the business, providing clients and investors a wholistic view of the transaction.