INSIGHT

Understanding the value of a quality of earnings report

January 30, 2025

Services: Quality of Earnings, M&A Tax Services

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A quality of earnings (QOE) report serves as a crucial tool in business transactions, providing an in-depth analysis of a company’s financial health and normalized cash flow. This comprehensive evaluation helps both sellers and buyers make informed decisions during the sale process. 

QoE report – The foundation of business valuation 

When determining a business’s worth, several key financial metrics come into play. These typically include earnings before interest, taxes, depreciation and amortization (EBITDA), free cash flow (FCF) and revenue. A quality of earnings report dives deep into these metrics, offering a detailed examination of adjusted EBITDA and highlighting factors that influence a company’s overall value. A QoE also provides analysis on normalized net working capital (NWC). 

“Many companies think having audited financials is enough for buyers. What they don’t realize is that professional investors require a QoE to validate their investment decisions. When we perform these analyses, we often find value-impacting adjustments that weren’t visible in standard audits. We’ve seen deals get delayed or derailed because sellers skipped this critical step, thinking their internal numbers were sufficient.”  

– Craig Hamm, BPM Partner and Transaction Advisory Group Leader. 

Understanding QOE reports vs traditional audits

While both serve important purposes, a quality of earnings report differs significantly from traditional audits. QOE reports focus specifically on transaction-related concerns and provide monthly analysis rather than annual reviews. They examine recent trends, particularly the trailing 12-month period, which proves crucial for value determination and debt financing. The granular analysis provides deeper insights into seasonal patterns and business cycles that impact company performance. 

Key components of a quality of earnings report 

• Report Scope and EBITDA Analysis: The scope varies based on factors such as industry specifics, market size and accounting complexities. A thorough analysis of adjusted EBITDA provides clarity on the company’s true earning potential without one-time or non-operational expenses. 

• Financial Position Assessment: The report examines net working capital and net debt positions, offering insights into financial stability and operational efficiency. 

• Operational Analysis: Comprehensive trend analysis covers key performance indicators (KPIs), customer relationships, vendor partnerships and workforce dynamics. 

• Historical Performance and Growth Potential: The report evaluates historical performance patterns and identifies potential areas for operational improvement that could impact valuation.  

Uncovering critical business insights 

During the QOE evaluation, several important factors come to light: non-recurring events and expenses that shouldn’t impact future valuations, non-operational expenses that need separation from core business activities, accounting discrepancies that require alignment with GAAP standards, pro forma adjustments reflecting recent operational improvements and customer concentration risks and vendor relationship dynamics. The evaluation also identifies potential synergies that could enhance value for strategic buyers. 

Measuring earnings quality

To assess the sustainability of business operations, a QOE report examines several key indicators that paint a comprehensive picture of financial health. Revenue trends and stability patterns reveal the consistency and predictability of income streams, while customer concentration levels highlight potential risks and dependencies in the revenue base. The analysis of gross profit and EBITDA margins demonstrates operational efficiency and pricing power within the market. 

Working capital requirements provide insight into the company’s operational efficiency and cash flow management. Days sales outstanding and days payable outstanding metrics inform the effectiveness of collections and payment processes, directly impacting cash flow. Annual recurring revenue potential helps forecast future earnings stability, particularly valuable in subscription-based or service-oriented businesses. 

Customer lifetime value calculations demonstrate the long-term revenue potential of the existing customer base. The QOE report also evaluates seasonal fluctuations, market-driven variations and industry-specific factors that might affect earnings quality. Understanding these patterns helps determine whether current performance levels are sustainable and identifies areas where operational improvements could enhance value. 

The quality of earnings report timeline 

A quality of earnings workbook and report follows a structured timeline, typically requiring four to six weeks for completion from start to finish. The process unfolds across several key phases: 

• Information Gathering: The process begins with collecting source information, including monthly financial statements. This initial phase sets the foundation for the analysis. 

• Analysis and Documentation: This critical phase typically spans one to two weeks as the team examines financials and prepares supporting documentation. 

• Review and Discussion: Review meetings follow to discuss findings and determine necessary adjustments to the analysis. 

• Final Report Preparation: The final workbook and report drafting usually requires an additional one to two weeks to complete. 

Working with BPM

A quality of earnings report represents a valuable investment in your company’s future, potentially increasing transaction value while reducing the time needed to close deals. By providing a clear picture of your business’s earning profile, the QOE report helps you understand how potential buyers will view your company, enabling you to make strategic decisions that maximize your sale outcome. 

BPM provides comprehensive support throughout the QOE process, working alongside investment bankers, attorneys and other advisors. We help articulate your company’s position on key risk areas and provide strategic guidance for maximizing your sale outcome. To find out more about how we can help you prepare a QOE report, contact us.