Quality of Earnings – Not all Income is Created Equal

January 23, 2019

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If you are acquiring or investing in a business, there are generally always risks associated with the deal. It is not uncommon for those financing the deal, including investors or lenders, to ask for a quality of earnings report. Since many purchasers often don’t understand the purpose of the report, we have written this short piece to provide some guidance on what a quality of earnings report is, and equally as important, what it isn’t.

Quality of Earnings Report

A quality of earnings (QE) report is an important component of financial due diligence during a transaction. As the name suggests, the objective is to assess the quality (or conversely, the risks) associated with the target’s reported earnings. Financial statements report historical earnings; however, they don’t provide insight into the likelihood of those earnings continuing into the future. The QE analysis is designed to bridge that gap.

While there are common elements in most QE reports, there is no standard requirement, so it is important to set the scope early on in the process. The scope should focus only on the areas that the purchaser or lender cares about, in other words, the deal breakers. If an issue would not change the purchaser’s decision to complete the transaction, then there is less value in performing analysis over that issue.

The starting point for a typical (QE) report is determining the normalized earnings before interest, tax, depreciation and amortization (EBITDA). In the majority of transactions, the purchaser has priced the deal based on an EBITDA multiple, or the lender has calculated the amount to lend using an EBITDA-based debt service ratio. QE analysis provides insight and clarity into whether the normalized EBITDA, often provided by the seller, is sustainable and appropriate for pricing the deal.

Another common area for analysis is revenue composition. This analysis may include sales by customer (customer concentration), product/service, geography or seasonality. The objective is to help the user understand the risks and opportunities associated with the revenue stream. The risk profile of a business with a single customer accounting for 80% of sales is different than a business with a diversified customer base where no single customer accounts for more than 1% of sales. Further, this analysis helps identify one-time, non-recurring transactions that might be inflating the normalized EBITDA. Issues identified during the QE analysis can lead to areas to be investigated during operational due diligence.

Though a sales analysis is an important component of the due diligence process, looking at them in isolation does not tell the entire story. In conjunction with revenue analysis, we typically perform an analysis on cost of sales and gross margin. A business preparing for sale wants to appear as attractive as possible. One strategy to achieve this may be to rapidly grow top-line revenues without having any regard to profitability. If the QE analysis can identify that the new sales are not profitable, then there is reason for the purchaser to discount the value of this growth.

Payroll can also be another important component of the QE analysis. Often, a purchaser may have plans to make personnel changes post acquisition, whether it is eliminating positions to reduce costs, or adding new positions to fill operational gaps. The payroll analysis will assess the impacts of those personnel changes.

For purchasers that hope to reduce general and administration expenses post acquisition, we may be requested to perform additional analysis in this area to help assess whether the expected cost reductions are reasonable.

With the volatility in exchange rates, analysis over the impact of foreign exchange is becoming increasingly important. The story told by the financial statements which have translated USD transactions into Canadian dollars may be very different than the story told when reviewing the revenues/expenses incurred in the original currency. As the Canadian dollar weakens, the financial statements for a business with significant sales in US dollars may show growth in sales, but that may be entirely due to the change in exchange rates used to translate the sales. A common QE procedure is to perform a trend analysis assuming a constant exchange rate was used throughout.

If you are looking to acquire a business, a QE analysis should be a part of your due diligence process. It is important to tailor the scope of the QE analysis to the areas of the business that are important to your acquisition decision.

For more information on how Smythe Advisory can assist your due diligence process, please contact Partner, Alex Wong at 604-694-7574 or awong@smythecpa.com.





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