What Is A Quality of Earnings Analysis?

Selling a business is a significant and stressful decision that requires careful consideration and planning. One crucial (and often misunderstood) factor that both sellers and potential buyers should pay closer attention to is the quality of earnings of the selling entity. In this article, we will explore the theory behind, definition, and significance of a quality of earnings analysis in the process of selling a company.

Quality of earnings refers to the comprehensive assessment and verification of a company's financial statements and records to ensure accuracy, compliance with accounting principles, and transparency before initiating the process of selling the business. To better understand this concept, let's draw an analogy with selling a house. Just as homeowners invest time and effort in preparing their house for sale (i.e., landscaping, roofing, electrical, or drywall) potential sellers must also ensure their financial "house" is in order.

During the quality of earnings analysis, experts thoroughly review the company's financial statements and records, asking pertinent questions to ensure accuracy and compliance with accounting rules. This process involves a meticulous examination of the books, assessing the validity of reported earnings and identifying any potential adjustments or management proposals. Once the analysis is complete and all compliance requirements are met, a formal report is generated, instilling credibility in the entire sales process and presenting the seller as well-prepared and transparent.

The purpose of the quality of earnings analysis is to enhance trust and confidence among potential buyers by providing a reliable and accurate financial representation of the business. Similar to how a well-prepared house attracts more potential buyers, a comprehensive quality of earnings analysis ensures that the financial records are in order, reduces surprises during due diligence, and allows the seller to address any identified issues proactively. Ultimately, this analysis serves to maximize the seller's credibility, increase negotiating power, and facilitate a smooth and successful sale of the business.

Understanding Why Earnings Quality Is So Important In M&A

Quality of earnings refers to the sustainability, reliability, and accuracy of a company's financial statements and the underlying factors that determine and contribute to its profitability. It focuses on the transparency and consistency of a business's net income, revenues, cash flows, and balance sheet.

When selling a business, the quality of earnings plays a pivotal role in determining its value and attracting potential buyers. A strong track record of reliable earnings reassures buyers about the stability and future profitability of the business they are acquiring. On the other hand, poor earnings quality raise concerns among investors and potential acquirers about the sustainability and accuracy of reported financials, which can significantly impact buyer interest, negotiation leverage, and ultimately the enterprise value of a selling entity.

In a recent conversation, Todd Sullivan, CEO of Exitwise, emphasized the growing importance of a sell-side quality of earnings analysis, stating, "Buyers are not just interested in the current period of earnings, but also the ability of the business to sustain those earnings going forward." This sentiment highlights the long-term perspective buyers adopt when assessing a company's financial performance.

Larry Simon, an experienced CPA and Partner at accounting firm Doeren Mayhew adds, "Buyers want to see consistent earnings growth over a reasonable period each fiscal year." Consistency in earnings demonstrates the business's ability to weather market fluctuations, adapt to changing industry dynamics, and generate stable cash flow, all of which are critical factors in buyer decision-making.

Factors Affecting A Company's Quality of Earnings

Several factors contribute to the assessment of a company's quality of reported earnings. Some key considerations in determining the quality of a company's earnings include:

Revenue Recognition

Accurate recognition of revenue is crucial to determining a business's true financial performance. Transparent and compliant revenue recognition practices instill confidence and credibility in financial accounting to potential buyers and prevent misleading portrayals of revenues, net income, and EBITDA.

Expense Management

Efficient cost control and a track record of effective expense management ensure sustainable profitability. Buyers scrutinize expense patterns to identify any irregularities or unsustainable spending, which may raise red flags or concerns about the business's future earnings potential.

Customer Concentration

Over-reliance on a few major customers poses risks to earnings stability. Diversification of income across a distributed customer base reduces the impact of losing key accounts and demonstrates the business's ability to sustain earnings even in changing market conditions.

Industry and Market Analysis

A comprehensive evaluation of industry dynamics and market trends helps potential buyers assess the long-term viability of a business's earnings. Understanding the competitive landscape, growth prospects, and potential risks enhances buyer confidence and in their eventual valuation of the business' assets.

Improving Your Business's Quality of Earnings

Sellers can take proactive measures to improve the financial snapshot of their company, and maximize their business's enterprise value during the sale process. Here are some strategies we like to lean on:

Strengthen Financial Controls

Implementing robust financial controls and accounting practices instills trust in potential buyers. Accurate and transparent financial reporting enhances the credibility of earnings and overall business performance. Typically there are two ways to ensure strong financial controls:

• Engage with an external firm to run a full quality of earnings analysis

• Work with your CFO or a trusted advisor to ensure the team managing your books is using industry best-practices and widely accepted accounting practices

Diversify Revenue Streams

Reducing dependence on sales of a single product or service, or a limited number of customers, enhances earnings quality (and reduces buyer risk). By diversifying revenue streams, businesses can demonstrate resilience and adaptability, making them more attractive to buyers.

Optimize Expense Management

Consistent and efficient expense management improves profitability and demonstrates financial discipline. By carefully managing costs and expenses and implementing sustainable expense reduction strategies, businesses can enhance their quality of earnings.

In recent years, we have seen a growing number of venture-backed companies that are not getting their next round of funding. This is due to a number of factors, including the rising cost of capital and the increasing competition for funding. When a company does not get its next round of funding, it can be forced to make cuts to its expenses. This can lead to layoffs, reduced marketing and development initiatives, and other negative consequences.

Properly managing your primary cost drivers can not only increase the likelihood of getting your next round of funding, but also make your business much more attractive for acquisition.

Long-Term Planning

Establishing a clear long-term growth strategy, backed by detailed reports and realistic financial projections, enables buyers to evaluate the potential return on investment. Demonstrating a well-thought-out strategic plan tied to a history of clean financials enhances the perceived quality of earnings and increases buyer confidence.

Conclusion

Ultimately, the quality of earnings of a company serves as a testament to measure a business's financial health, stability, and potential for future growth. Sellers who prioritize and actively manage the factors that contribute to earnings quality not only enhance their chances of attracting buyers but also increase their negotiating power and ultimately achieve a favorable outcome in the sales process.

Quality of Earnings Resources

For additional information regarding the topic of quality of earnings:

• Cashing Out Podcast: listen to M&A industry experts Todd Sullivan (CEO, Exitwise) and Larry Simon (CPA/Partner, Doeren Mayhew) discussing enterprise value and QofE during a recent Exitwise M&A Live Event and Cashing Out podcast episode.

• Mergers & Acquisitions Explained: Quality of Earnings Q&A