What is the Purpose of a Quality of Earnings Report?

If your exit plan includes selling your business, you can likely expect the potential buyer to request a Quality of Earnings Report. Obtaining a Quality of Earnings Report (QER) is one of the major steps in due diligence that a prospective buyer will perform to determine the quality of assets and identify financial shortcomings of the private target company.

The net income reported on the statement of income may not necessarily be a 100% accurate indication of the financial performance of the business. It is possible in some cases for a business to report large net income figures and negative operating cash flow. 

The resulting Quality of Earnings Report (QER) will demonstrate, among other things, how the company accumulates its revenues such as cash and non-cash, recurring or non-or nonrecurring.

There are many key details that are not outlined in the company’s income statements, so a breakdown of cash sources is very important. More specifically if the target company reports a positive net income but poor-quality earnings, the buyer may be looking at a more risky investment than the profit and loss statement might indicate.

Reviewed or audited financial statements are typically referred to in the QE assessment, although a QER is not as precise as these documents. However, when information presented on a tax return can be tied back to the company's QuickBooks and/or other external source documents, it lends support to the assumption that the revenue stream will support the purchase price.

Following is an example of the information that will be included in a Quality of Earnings Report.

• Executive Summary
  • Business Overview
    • Org Chart including related responsibilities
  • 10 Value Drivers
    • A stable high-performing workforce
    • Sustainable systems
    • Diverse customer base
    • Good facility appearance
    • Realistic growth strategies
    • Key performance indicators for financial controls
    • Cash flow profitability, revenue, low debt
    • Attractive business sector
    • Strategic forward-looking plan
  • Transaction Overview
    • Summary of Key Issues & Recommendations
      • Type of transaction
      • Funding of transaction
      • Assets acquired
      • Goodwill acquired
  • Summary of Key Issues and Recommendations
• Income Statement
  • Revenue analysis
  • EBIDA Calculation
  • Normalization adjustments
  • Adjusted EBITDA
• Balance Sheet
  • Projected Balance Sheet
    • What assets are acquired
    • What Debt is incurred
• Purchase Price Allocation
  • Hard Assets
  • Goodwill
  • Tax Consequences
• Conclusion
  • Comments & Suggestions & Recommendations
  • How bankable is the transaction?

Many acquisition transactions fail during the due diligence process as the reviews highlight the key failings of a target company that would not have been discovered without an external audit. Obviously, it’s important to have thorough and accurate books that support your financial claims. The recommendations in a quality of earnings report constitute professional analysis and advice but are not required to be followed by either the acquirer or the target company.

I’d welcome the opportunity to help you assess your company’s financials and financial processes. Contact me to ensure that your company’s performance is aligned with your strategy and objectives.  

Visit our events page and stay up to date on exit planning boards, seminars, and events.