INSIGHT

The impact of quality of earnings analysis on business transactions

February 5, 2025

Services: Quality of Earnings

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When selling or buying a business, understanding the true financial health of a company becomes paramount. A quality of earnings (QOE) analysis serves as a powerful tool that illuminates the actual financial performance and sustainability of a business, helping both buyers and sellers make informed decisions during transactions. This comprehensive evaluation plays a vital role in modern mergers and acquisitions, particularly in middle-market deals where accuracy and transparency drive successful outcomes. 

“What we’re seeing in the market right now is fascinating,” says Craig Hamm, BPM Partner and Transaction Advisory Group Leader. “We’re experiencing a surge in QOE requests as seller activity picks up, and sophisticated investors are doing more than just asking for this analysis – they’re diving deep into the findings. Through these engagements, our team consistently uncovers insights that radically change how a business is valued. That’s why starting this process early is critical – it gives everyone a clear picture of what’s actually driving business performance.” 

Breaking down the Quality of Earnings analysis process 

At its core, a quality of earnings analysis examines the fundamental components that drive a company’s financial performance. This evaluation looks beyond surface-level financial statements to reveal the sustainability and accuracy of historical earnings while assessing future earning potential. The process demands meticulous attention to detail and a thorough understanding of accounting principles, business operations and industry dynamics. 

The analysis typically spans three to four weeks and involves a detailed review of several key areas: 

Adjusted EBITDA assessment 

The analysis begins with a thorough examination of earnings before interest, taxes, depreciation and amortization (EBITDA). This metric provides valuable insights into a company’s operational performance by focusing solely on core business activities. The process involves making critical adjustments to account for various factors that might influence the financial picture. These adjustments help create a clearer understanding of the company’s true earning potential and operational efficiency. 

These adjustments fall into three main categories: 

• Due diligence adjustments that normalize expenses and align revenue recognition with accepted accounting principles 
• Management-proposed adjustments that account for extraordinary items and one-time events that may distort the financial picture 
• Proforma adjustments that reflect anticipated future changes in operations and their potential impact on earnings 

Proof of cash verification 

The analysis validates cash performance and trends by comparing bank statements with reported financial data. This step ensures that reported earnings align with actual cash transactions, providing potential buyers with confidence in the financial statements’ accuracy. The verification process also reveals important patterns in cash flow management and identifies potential areas of concern or improvement. 

Working capital evaluation 

Understanding a company’s working capital position reveals its operational efficiency and cash management capabilities. This evaluation examines current assets and liabilities, helping determine the business’s actual cash requirements for daily operations. The analysis considers industry standards, seasonal fluctuations and company-specific factors that influence working capital needs. 

Industry considerations and benchmarking 

Different industries maintain unique characteristics that influence the quality of earnings analysis. Seasonal businesses, for example, require special attention to cyclical patterns, while manufacturing companies often need detailed inventory analysis. The evaluation process incorporates industry-specific benchmarks and best practices to provide meaningful context for the findings. 

Impact on business transactions 

The findings from a quality of earnings analysis can significantly influence transaction outcomes. Since many middle-market deals use EBITDA multiples to determine enterprise value, each adjustment identified during the analysis may affect the final purchase price. Understanding these implications helps all parties negotiate more effectively and reach mutually beneficial agreements. 

The process requires active participation from business owners, who must provide detailed financial information and engage in management meetings. These sessions can range from brief discussions to extensive multi-day reviews, depending on the business’s complexity. Clear communication and prompt responses to information requests help maintain momentum throughout the analysis. 

Keys to success 
To maximize the value of a quality of earnings analysis, consider these essential factors: 

• Maintain detailed financial records and documentation throughout the year
• Prepare for in-depth discussions about business operations and financial decisions
• Understand the potential impact of identified adjustments on valuation 
• Stay engaged throughout the analysis process to address questions promptly 
• Consider preliminary internal reviews to identify potential areas of concern 

Supporting your transaction journey 

When navigating the complexities of business transactions, working with BPM provides you with support and guidance to achieve optimal outcomes. Our dedicated team conducts thorough quality of earnings analyses that help identify potential areas of concern while highlighting opportunities for value enhancement. 

Our extensive experience in middle-market transactions enables us to deliver precise, actionable insights that support successful deals. By partnering with BPM, you gain access to professionals who understand the nuances of quality of earnings analyses and their critical role in transaction success. 

To learn how our quality of earnings analysis services can support your business transaction goals and help you achieve the best possible outcome in your next deal, contact us today.