Quality of Earnings Report: The Key to Accurate Financial Due Diligence

Attracting investors, securing financing, and building a reputable brand are crucial for any business. To achieve this, showcasing a strong financial performance is essential. However, financial statements can be misleading, particularly when they do not reflect the true financial health of a company. That’s where a Quality of Earnings (QoE) Report comes in.

What is a Quality of Earnings (QoE) Report?

A Quality of Earnings Report is simply put, a due diligence report that helps evaluate the true financial health of a company. It is a document that assesses the quality, sustainability, and accuracy of various financial statement items such as revenues, expenses, gains, and losses. 

It helps to identify any non-recurring or unusual items that may impact the company’s future earnings. For example, if a company has unusually high one-time gains in a particular period, it may not be sustainable in the future.

In addition to the financial statement analysis, the Quality of Earnings Report may also include a review of the company’s accounting policies and practices. This can help to identify any potential areas of concern, such as aggressive revenue recognition or inadequate allowance for bad debts.

Why is a Quality of Earnings Report needed?

A Quality of Earnings Report is critical for businesses that are: 

1. Looking to raise capital, 
2. Acquire another company, or 
3. Sell their business. 

It is also helpful for investors who want to verify the financial health of a company before making investment decisions.

A QoE Report is important for businesses for several reasons:

1. Provides an accurate financial picture of the business by providing a comprehensive view of a company’s financial health, which is critical for decision-making.
2. Helps identify areas of concern by highlighting areas of concern, such as irregularities in revenue recognition or excessive expenses, that need to be addressed to ensure the sustainability of the business.
3. Helps in M&A transactions by providing potential buyers with a detailed analysis of the company’s financial performance, enabling them to make informed investment decisions.

Sample of Quality of Earnings Report

In the world of mergers and acquisitions, it is essential to conduct a thorough M&A due diligence review before any transaction takes place. In this section, we will delve into a hypothetical example of a quality of earnings review conducted, when ABC Corporation, a large publicly traded company decides to acquire the privately held XYZ Corporation. 

The review is separated into 4 key sections:

1. Executive summary
2. Profit and Loss
3. Balance sheet
4. Cash flow

Case Study: ABC Corporation evaluating acquisition of XYZ Corporation and commissions a Quality of Earnings Report to evaluate its financial health

ABC Corporation, a large publicly traded company, is interested in acquiring XYZ Corporation, a smaller private company that specializes in manufacturing and selling industrial equipment. Before making an offer, ABC Corporation wants to evaluate the financial health of XYZ Corporation by commissioning a Quality of Earnings Report.

1. Executive Summary

The executive summary provides a concise overview of the financial health of XYZ Corporation. It highlights key findings, strengths, weaknesses, and risks, and offers an overall assessment of the quality of earnings. 

For example, in this case, the executive summary of the Quality of Earnings Report highlights the significant financial risks that ABC Corporation might face if it decides to acquire XYZ Corporation. It includes a list of red flags and deal breakers, which could negatively impact the value of the acquisition.

Some of the potential red-flags and deal breakers that ABC Corporation might have encountered during the Quality of Earnings Report for XYZ Corporation include:

Red Flags:

• Declining earnings over the past few years
• Negative working capital
• High customer concentration
• Significant changes in revenue recognition practices
• High levels of accounts receivable or inventory

Deal Breakers:

• Significant undisclosed liabilities or legal issues
• Fraud or material misstatements in financial statements
• Inability to repay debt obligations
• Inadequate working capital to support operations
• Significant tax liabilities or disputes with tax authorities

It’s essential to note that these red flags and deal breakers are not specific to this case study and may vary depending on the industry, size, and nature of the target company. By thoroughly evaluating the target company, the acquiring company can make a well-informed decision that ensures a successful acquisition.

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2. Profit and Loss

The profit and loss section of the report provides a detailed analysis of XYZ Corporation’s sustainable earnings. It may include information such as revenue growth rates, gross profit margins, and operating expenses.

EBITDA (earnings before interest, taxes, depreciation, and amortization) is a common measure of a company’s financial performance. However, it may not reflect the sustainable earnings of the company. Therefore, we have adjusted the EBITDA to account for non-recurring expenses and unusual items, which may distort the financial performance of the company. 

The following formula is used to calculate normalized EBITDA:

Normalized EBITDA = EBITDA + Non-recurring expenses and unusual items – Non-recurring income and unusual items

Let’s use a simple profit and loss statement of XYZ Corporation to understand about Normalized EBITDA better:

As we can see from the table, EBITDA for XYZ Corporation is $15 million. However, to get a better understanding of the sustainable earnings of the company, we need to adjust the EBITDA to account for non-recurring items and other adjustments. Once we make these adjustments, we get the Normalized EBITDA of $23 million.

3. Balance Sheet

The balance sheet section of the report provides an analysis of XYZ Corporation’s assets, liabilities, and equity. It may include information on liquidity, working capital, and debt levels. 

However to get a clearer picture of what does a balance sheet reflect, we need to first:

1. Check requirements to net working capital
2. Analyze net debt position

Analyzing the net working capital and net debt position of XYZ Corporation is important for the acquirer as it provides valuable insights into the company’s ability to meet its short-term financial obligations and service its debt. This information can be used to inform the decision of whether or not to acquire the company, as well as to negotiate the terms of the acquisition.

Let’s understand this with an example. A sample balance sheet of XYZ Corporation as of December 31, 2022 is presented in the following table:

A) Check requirements to net working capital:

Analyzing the net working capital of the company is crucial to ensure that the company has enough working capital to operate its business. It is calculated by subtracting current liabilities from current assets. 

Net Working Capital = Current Assets – Current Liabilities

The net working capital of XYZ Corporation is $15 million ($45 million – $30 million). This indicates that the company has a strong ability to meet its short-term financial obligations, which is a positive sign for the acquiring company.

B) Analyze net debt position:

Analyzing the net debt position of the company is also important for the acquirer, as it helps to evaluate the financial risk associated with the company’s debt. Net debt is the difference between total debt and cash and cash equivalents.

Net Debt = Long-term debt + Short-term debt – Cash and cash equivalents

The net debt of XYZ Corporation is $60 million ($40 million in non-current liabilities + $30 million in current liabilities – $10 million in cash and cash equivalents). This indicates that the company has a significant amount of debt that it will need to service, which is a potential risk for the acquiring company.

Overall, the balance sheet analysis provides valuable insights into the financial position of XYZ Corporation, and helps to ensure that the company has sufficient working capital to meet its current liabilities, and is not overly leveraged.

4. Cash Flow

Cash flow analysis provides valuable insights into the cash position of any company, and helps to ensure that the financial statements provide an accurate representation of the company’s financial performance.

To ensure the accuracy of the cash flow statement, we need to:

1. Obtain overview of cash flow
2. Check financials to tax returns
3. Reconcile transactions per bank statements to accounting records

Let’s understand this with an example. A simplified sample Cash Flow Statement for XYZ Corporation (Year Ended December 31, 2022) is presented in the following table:

A) Overview of cash flow: 

The Cash Flow statement provides an overview of the cash inflows and outflows from operating, investing, and financing activities. The net increase in cash and cash equivalents is $0, which indicates that the company’s cash position has remained relatively stable over the year.

B) Check financials to tax returns: 

To ensure the accuracy of the cash flow statement, check the financials to tax returns to ensure that the cash flow reported in the financial statements is consistent with the tax returns. Any inconsistencies may indicate issues with the company’s financial reporting, such as understating or overstating revenues or expenses, which could affect the acquirer’s evaluation of the company’s financial health.

C) Reconcile transactions per bank statements to accounting records: 

Additionally, reconcile the transactions per bank statements to the accounting records to ensure that the cash transactions are accurately recorded in the financial statements. Any discrepancies could indicate that the company has not properly recorded all of its transactions, which could also affect the acquirer’s evaluation of the company’s financial health.

Additional information that may be included in any of the three sections could be the following:

• Comparison to industry benchmarks or competitors
• Explanation of any significant accounting policies or estimates
• Discussion of any significant one-time or non-recurring items affecting earnings
• Analysis of revenue and expense recognition policies and practices
• Evaluation of the quality of earnings based on cash flow analysis, accruals, or other metrics

Based on the findings of the Quality of Earnings Report, ABC Corporation can make an informed decision about whether or not to proceed with the acquisition of XYZ Corporation. The report provides valuable insights into the financial health of the company and can help ABC Corporation identify potential risks and opportunities associated with the acquisition. 

For instance, if the report highlights concerns about inventory management, ABC Corporation may negotiate for changes to be made in this area as part of the acquisition agreement.

Quality of Earnings Report vs Audit

While both an audit and a QoE report involve financial analysis and are important tools for assessing the financial health of a company, they serve different purposes, scopes, and focuses. here’s a table to compare and contrast the key differences between an audit and a Quality of Earnings (QoE) report:

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Our team of experts includes CPAs, financial analysts, accountants, and consultants who work together to provide clients with comprehensive reports. We use industry-standard methodologies and tools to prepare accurate and reliable reports that meet the needs of our clients.

Our team prepares a detailed report that highlights the company’s financial performance, the quality of its earnings, and any potential issues. We provide our clients with a clear and concise analysis of the financial data, including graphs and charts that illustrate the trends and patterns. Our reports are customized to meet the specific needs of our clients, and we provide recommendations for improving the company’s financial performance.

Quality of Earnings Report cost

At OGSCapital, we believe that Quality of Earnings Reports (QoE) should be accessible to every business, no matter their size or industry. That’s why we offer highly competitive pricing for our QoE services without compromising on quality or accuracy.

Our pricing is based on the size and complexity of the company and the number of years covered by the report. Our pricing structure is transparent, and we always discuss it upfront with our clients to avoid any surprises. We believe in building long-term relationships with our clients and always strive to provide the best value for our services.

When you choose OGSCapital, you can be confident that you are receiving the best possible Quality of Earnings Report service at a competitive price. Our team of experts is dedicated to helping your business succeed, and we are always available to answer any questions you may have.

If you are looking for a high-quality, accurate, and competitively priced QoE report, look no further than OGSCapital. Contact us today to learn more about our pricing and services and how we can help your business succeed.

FAQ

1. Does the Quality of Earnings Report look at inventory?

Yes, the Quality of Earnings report does look at inventory as it is a crucial aspect of a company’s financial performance. The QoE report analyzes non-operating expenses, non-recurring items, and other factors that can affect earnings, including inventory. The report examines inventory levels, valuation methods, obsolescence, and any reserves related to inventory to provide a complete picture of the company’s financial health.

2. Who can perform a Quality of Earnings Report?

CPAs are necessary to prepare Quality of Earnings Reports (QoE) as they have the expertise to accurately analyze and interpret financial statements. We at OGSCapital offer an experienced and qualified team of experts, including CPAs who specialize in preparing QoE reports. Our team ensures the reports are customized to the specific requirements of each client and are in compliance with GAAP. By hiring OGSCapital, you can be confident that your QoE reports are comprehensive and accurate.

If you require a Quality of Earnings report, OGSCapital can provide a team of qualified CPAs who specialize in preparing these reports. Contact OGSCapital today to learn more about how they can help you with your QoE report needs.