Is a full Quality of Earning always necessary? – what an important question

Is a QoE always necessary? – what an important question It is sometimes difficult to justify spending tens of thousands on a QoE report, particularly on a small deal. A Buyer sometimes ends up in a "so what" situation after going through pages of tables and commentary. There are several reasons to doubt the value of a QoE report. The blame is on both the potential Buyer and the QoE provider. Poor scoping, unclear objectives, and a lack of well-articulated findings, implications, and conclusions are the significant causes of value-less QoE reports. In principle, the Quality of Earnings is the most crucial part of any deal. The reason is a no-brainer. Only if we realise that what the acquirer is keen on and thus buying are earnings – future earnings (a stream of future cashflows). The "business" is just a means to an end – without the earnings, there is no transaction. Taking the time and resources to deep-dive into the "quality" of what one is buying—earnings—is a foregone conclusion. When well-scoped and diligently performed, a quality of earnings report makes clear the risks and opportunities surrounding the business's earnings.

From my experience, the most sophisticated Buyers go all out regarding financial due diligence. It is not that they have resources, but they are often aware that a DD/QoE review is the best chance to dig deep,. “High Quality” Earnings Broadly, "high-quality" earnings reflect the company's current operating performance and are a good indicator of future operating performance. It is a useful summary measure for assessing the value of the business. Taken as a whole, the quality of earnings can generally be summarized as the degree to which earnings are cash or noncash, recurring or nonrecurring, and based on precise estimates. The primary purpose of a QoE review is to evaluate the company's performance and assess the extent to which current performance is indicative of future performance, i.e., maintainable or sustainable. A Buyer should keenly assess and understand the historical earnings, far much more than potential lenders. Merely analysing the three sets of financial statements is certainly not enough to understand the key drivers, opportunities and risks of a business.

Set Clear Objectives When Performing a QoE Analysis A QoE analysis is crucial for potential buyers when acquiring a small business. It can serve multiple objectives, essential for making informed investment decisions and ensuring the smooth integration and operation of the target company post-acquisition.

1. Making the "go" or "no-go" investment decision The analysis helps the Buyer decide whether the investment aligns with their strategic and financial goals by highlighting potential financial risks/rewards. In practice, Buyers make the "go" decision before the "official" QoE. Experienced Buyers tend to split their due diligence into two phases: internal (red flag) and external (comprehensive). A red flags DD is broadly a light-touch financial analysis by an informed/experienced professional, focusing on key deal breakers.
2. Validating Key Investment Thesis Assumptions and Business Drivers A QoE report examines assumptions such as high growth and high margin projections that underpin the investment thesis. By clearly articulating the historical/current drivers a Buyer can objectively assess the sustainability and accuracy of model assumptions. Several Buyers make the mistake of validating model assumptions using external industry/economic data instead of internally achieved historical data. Small businesses have unique characteristics that often enable them to easily perform well in a struggling industry or underperform in an otherwise stable industry. Relying heavily on industry wide trends in evaluating small businesses can lead to missed risks and opportunities. Buyers should always be skeptical of any forecast/model with costs less than historical or revenues more than historical.
3. Validating Key Valuation Inputs Depending on the deal/valuation structure, a QoE report scrutinizes valuation inputs such as normalization adjustments (to reflect sustainable earnings) and working capital adjustments. When making an offer, Buyers for small businesses sometimes need to clearly articulate in the Letter of Intent how findings from the QoE report are to impact/adjust valuation or deal structure. A proposed valuation structure, for instance, would apply a multiple to "adjusted" earnings from the QoE analysis (subject to negotiating the adjustments). Low/excess working capital should form part of the other key adjustments.
4. Key Sale and Purchase Clauses to Reduce Risk Key findings from the QoE should guide the formulation of sale and purchase agreement clauses such as warranties, indemnities, and earn-outs. These clauses protect the Buyer from future risks identified during the QoE process.
5. Closing and Post-Close Process The QoE informs the closing and post-acquisition integration process by identifying any financial discrepancies that need resolution before finalizing the transaction. It also helps in planning for the operational and financial integration of the business post-closure.
6. Working Capital Funding Requirements The QoE helps estimate the business's future working capital needs by examining historical working capital trends and requirements. This is crucial for planning the financing needed post-acquisition to support ongoing operations.
7. Reliability and Quality of Financial Information The QoE assesses the reliability of financial data by examining the company's accounting practices, reconciliations, use of modern accounting systems, and internal controls. This evaluation helps determine the dependability of financial statements and the robustness of the company's financial reporting processes. Overall, a Quality of Earnings report is integral in providing a potential buyer with a clear, comprehensive financial picture of a business, highlighting areas of concern, and validating the financial assumptions associated with the acquisition. This thorough due diligence process ultimately aids in mitigating risks associated with the investment.