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What is a Quality of Earnings Report?

Jonah Pollone

Seller Articles Seller FAQ Valuation

If you’re in the process of selling a business that does more than $1 million in EBITDA, then you may have heard the term “quality of earnings (QoE)” floating around, especially as you approach due diligence.  

You may be wondering what a quality of earnings consists of, what it means for the value of your business, and how it differs from an audit.  In this blog, we’ll break down the purpose of a QoE, the difference between a QoE and an audit, and what documents you can expect to be requested while a QoE is being prepared.  

Lets jump in! 

Quality of Earnings Defined 

A QoE (said "Q of E") is a report that analyzes a company’s presented financials to better understand the company’s historic earnings and future performance. This report is prepared by a third party (usually an accounting firm) hired by the buyer to confirm that a company’s adjusted EBITDA is accurate in both amount and source (we’ll get to that shortly). 

To confirm this, a CPA will review detailed data from a seller's financials, bank statements, ledgers, customer information, transaction level data, etc. to create a full picture of how a company earns profit. 

Many M&A Advisors and CPAs use the analogy of taking a car to a mechanic for a pre-purchase inspection before purchasing it to explain a QoE.  

You may be purchasing a car that doesn’t appear to have any problems. The exterior looks fine, the engine light isn’t on, it isn’t making any funny noises when you take it for a test drive, and the sales person assures you that there’s nothing wrong with it. But that doesn’t mean it’s in perfect condition.  

To make sure that the car you’re buying is operating as advertised, you’ll want to have a mechanic comb through it and identify any current or future problems that the car may have.  

This also applies to buying a business. Even if a business has clean audits and financials, a buyer will still want to have a QoE report done to make sure that there aren’t any surprises later down the road. 

Audit vs. Quality of Earnings

You may be saying to yourself, “but wait, shouldn’t an audit be enough to fact-check my business’s earnings?” Well, yes... and no.  

While an audit does fact check a business’s financials, it isn’t nearly as detailed as a quality of earnings report, and is used for different purposes that are usually tax related. To give you a better understanding, let’s take a look at some of the differences between the two. 

Audit 

Simply put, an audit is used to provide reasonable assurance that a company’s financial statements are free from material misstatement. In essence, audits confirm that the reported earnings match the actual earnings in a given fiscal year.  

Something else that an audit focuses on is verifying that a company’s financial statements conform to the relevant accounting standards (US GAAP). Essentially, this verifies that all of the accounting methods are legal and free of fraud.  

Audits take into consideration other things too (like internal controls, account balances, and analytical procedures), but the main way that an audit differs from a QoE is in its purpose, which isn’t generally geared toward buyers or investors as an audience.  

Quality of Earnings 

A quality of earnings report, on the other hand, is much more detailed and is tailored to a buyer or investor's needs.  

The purpose of a QoE is to learn about the quality and source of a business’s earnings. While a QoE is usually performed by a third party hired by a buyer, it’s also common for a business owner to have someone run a QoE on their business to have a more detailed understanding of their business’s earnings and help the sale of their business run smoother.  

During a QoE, the accounting firm will try to figure out two main things: 

  1. Is a business making as much money as the seller claims it is? (Amount) 
  1. What are the primary sources responsible for the business’s earnings? (Source) 

The first thing to determine is if the number used to represent a business’s earnings is accurate. Some companies use aggressive accounting methods that either inflate profits or creatively represent expenses in order to make their company look more attractive to buyers or investors. 

It is the job of those performing a QoE to discover any of these aggressive accounting methods and analyze how much money is actually flowing in and out of a business. 

The second thing to determine is the source of a business’s profits. This is where a QoE differs greatly from an audit, and where the really detailed accounting comes into play. To do this, the accounting firm will do a detailed dive into the individual products or services that generate a business’s profits to rule out a few possibilities. 

One thing they are trying to rule out is if a high concentration of profit is tied to a non-recurring source, such as an unusually large job or sale that isn’t typical of that business.

They are also looking to make sure that there isn’t a high concentration of profit that is tied to only a handful of customers, which poses certain risks for future profitability if one of those customers is lost.  

Some other things that a quality of earnings report may analyze are: 

  • Has the business lost any key customers 
  • To what extent is the business driven by non cash sales, and what is the likelihood that those receivables will be collected 
  • Profitability by division and location
  • What is the seller’s adjusted EBITDA, and how does it compare to the EBITDA that had been reported by the seller. 

QoEs can differ depending on a business’s size and industry, as well as what the buyer wants to take a closer look at.  

This report isn’t just a way of fact checking financials and looking at numbers; it also helps a buyer gain an understanding of what risks may be involved in taking over a business. 

Quality of Earnings Examples

To give you a better understanding, let’s take a look some examples of findings in a QoE.  

Example 1 

ABC Landscaping Co. is undergoing a QoE. Their financials are clean, and their accounting policies meet all the GAAP requirements, but there’s one problem: the business has an excessive concentration of revenue with one customer that contracts them for half of their jobs, making up 50% of their earnings.  

With this information, the buyer now must consider if they are willing to take the risk of ownership over a landscaping company that could lose half its profits if that customer decides not to renew their contract with ABC Landscaping Co. next year.  

The earnings reported are accurate, but the quality of those earnings is now under scrutiny because of the increased risk that profits won’t remain consistent if one customer is lost.  

Example 2

Main Street Construction Co. does $10M in revenue. In an average year, they will be hired for 1,000 jobs, some repair and some installation, but the financials for both of these job types are combined. 

The QoE report may break down the revenue and EBITDA shown on the Profit and Loss statement (P&L) into the amount earned on each job. When this is done, the QoE reveals that repair jobs are far more profitable than installation jobs.

Similar to example one, the new owner now has to consider if they are willing to take over a business in which one type of job makes up the majority of earnings, with the risk of profits falling if suddenly the company sees a decrease in that type of job.  

There may also be significant equipment upkeep or licenses required to continue performing the less profitable jobs, which the new owner now has to consider as less rewarding expenses.  

Documents Requested for a Quality of Earnings

The list of documents that will be requested during a QoE includes typical due diligence requests with things like tax returns, P&Ls, and balance sheets. 

It also starts to include much more detailed reports about specific parts of a business. The following list contains examples of documents that we’ve seen requested, but it’s unlikely that a buyer will ask for all of them.  

  • A list of customers with revenue for each last year 
  • Copies of all key contracts to verify the terms  
  • A list of every job you performed last year 
  • General ledger or account ledgers for important accounts 
  • A copy of QuickBooks files or access to ERP to pull reports 
  • Monthly financial statements for 3 – 5 years  
  • Detailed aging information on accounts payable 
  • Detailed employee information to confirm salary and benefits 

Takeaways 

In short, a quality of earnings report is a detailed analysis tailored to a buyer’s requests that analyzes both the amount and source of a business’s earnings. Its primary purpose is to check for anything that may indicate risk for the buyer, and better inform them of where a business’s profits come from.  

A QoE differs from an audit in that it also analyzes quality instead of just accuracy and legality.  

At MidStreet, we’ve seen several QoE reports done, and have a professional understanding of what they entail. If you still have questions, or would like to inquire about how MidStreet can make the QoE process easier on you, contact us today. We’d be glad to help! 

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