Why Do I Need a Quality of Earnings Report?

If you are trying to sell your business, transparency is the name of the game. By lifting the curtain—revealing the inner workings of the business and its financial performance—you can help instill confidence and certainty in a would-be investor. 

To that end, a quality of earnings report can enhance the due diligence process surrounding a private acquisition. This highlights the company’s strengths and flags potential deal breakers. 

For instance, a company that has a significant net income, but maintains negative cash flow or poor quality earnings, could wind up being an underperforming investment. 

Without a quality of earnings report, it would be difficult to determine whether that is true. 

What Is a Quality of Earnings Report? 

A Quality of Earnings Report—sometimes referred to as a QoE or a QofE report—supplies potential investors with valuable insights into a company’s historical operations, earnings, and performance. It tells them exactly how the business accumulates its revenue.

Typically, a QoE is conducted by an independent accounting firm. In that role as financial assessor, the expert will take a deep dive into the company’s 3- to 5-year historical, financial, and operating data. Their purpose is to provide an unbiased evaluation of financial operations.

This meticulous financial analysis is an essential part of the due diligence process. 

But it is not an audit. 

A QoE is more focused on the economic earnings and not the balance sheet. And from a legal standpoint, an audit has greater potential materiality (relevance and significance).  

The emphasis of this report is on earnings before interest, taxes, depreciation, and amortization (EBITDA), which is a strong performance indicator of a company’s cash flow-generating abilities. That said, the exact use and format of a QoE depend on who is requesting the report: the seller or the buyer. 

• For seller-side QoE – Sellers might order this type of report to uncover potential red flags that could disrupt or kill the sale. 
• For buyer-side QoE – Buyers might order a QoE to understand the company’s EBITDA in order to judge whether the listing price is fair. 

What Is Considered Quality Earnings? 

There is no single definition of what is or is not considered high-quality, but certain factors can help assess the quality of a company’s earnings. Per Deloitte, the quality of earnings comprises: 

“The degree to which earnings are cash or noncash, recurring or nonrecurring, and based on precise measurements or estimates that are subject to change. Evaluating the quality of earnings will help the financial statement user make judgments about the ‘certainty’ of current income and the prospects for the future.”

On the one hand, high-quality earnings tend to be sustainable and reflect free cash flow. In other words, they are repeatable over a series of reporting periods. On the other hand, lower quality earnings, which are not necessarily a negative indicator of the company’s health (or lack thereof), simply reflect that the transactions are higher risk and less certain. 

For example, a company that increases its earnings via internal measures would have high-quality earnings. But a company that increases its earnings thanks to external market forces would have low-quality earnings. 

What Is Included in a Quality of Earnings Report? 

The format of a quality of earnings report may vary according to the type of business, the industry, and the current market conditions.

That said, there are 5 core sections that practically every report will include: 

1. Executive summary – The executive summary provides a business overview, listing relevant details like the company’s location, age, founder, executive hierarchy, products, services, customer base, and so on.  
2. Income Statement Analysis – The income statement is the primary focus of a QoE report, demonstrating the company’s ongoing earnings and cash flow potential as measured by EBITDA.  
3. Quality of Net Assets (Balance Sheet) – This section reviews the balance sheet to see what the company owns (assets) in light of what it owes (liabilities). The strength of the balance sheet is measured according to working capital, asset performance, and capitalization structure. 
4. Working Capital Analysis – This analysis reveals the amount of liquid assets a company has available. Broadly speaking, the more working capital a company has, the better.
5. Quality of Earnings Analysis – In this conclusion, the assessor summarizes their findings, lists potential issues, and recommends whether the acquisition should be pursued. 

Benefits of a Quality of Earnings Report

Are you considering selling your company? 

Here are a few of the advantages you can gain by performing a sell-side QoE report: 

• Exposing accounting issues – If there are flaws in your accounting process, if you fail to abide by GAAP, the report will reveal these inherent structural issues. Your financial statements will be analyzed for compliance with GAAP.
• Expediting the transaction process – By requesting a QoE, you can fully prepare the company for a sale. This report will help you anticipate questions and address issues the buyer may have. As a result, there will be fewer surprises, and you may eliminate post-letter of intent (LOI) delay. 
• Controlling processes – Performing due diligence allows you to see how the buyer will likely react to the company’s adjusted EBITDA. As a result, you can confidently establish the optimal sales target without fear of being blindsided by an underwhelming QoE report. 
• Enhancing credibility – Proactively having an independent third-party review your financial statements adds credibility to their strength and veracity. You can demonstrate to would-be buyers that you are confident in the company and honest in your dealings.
• Avoid future price renegotiations – If you set a fair and accurate sale price—one that is aligned with your financial metrics and quality of earnings—you mitigate the probability that the buyer will return with a lowball offer.