Reasons to Perform a Quality of Earnings (QofE) Check Before or During Due Diligence
As much as we would like to convince ourselves otherwise, accounting is two parts science to one part art. Even the smallest difference in accounting conventions can lead to significant differences in the bottom line in any one financial year. When it comes to M&A transactions, this reality has a tendency to bring out the artist in many brokers and intermediaries.
Furthermore, this isn’t unique to the middle and lower middle market. A 2017 Wall Street Journal article noted that shareholder lawsuits for disappointing earnings were on the rise. It stated: “Traditionally, the most lucrative cases for plaintiffs have hinged on misstatements within audited financial statements, which can come to light when a company announces plans to revise previously reported results.”
This shouldn’t necessarily be taken as dishonesty; the job of any good intermediary is to maximize value for their client, and aside from the typical exuberance in the sales memorandum, an easy way to add value is through adjustments to the financial statements. These adjustments will often be open to interpretation (hence, the one part art), meaning buyers should be ready to conduct a quality of earnings check.
A quality of earnings check essentially confirms whether the business valuation that’s being sought for a business is fair and realistic from the buyer’s perspective. What this equates to is whether the earnings – and projected earnings – have been presented in a way which reflects the buyer’s point of view, rather than that of the seller, but also, critically, it analyzes the sustainability of the financial results in question.
The sooner this process is conducted, the better. Broadly speaking, there are three reasons why performing a quality of earnings check should happen either before or during the due diligence phase. These are outlined below.
Quality earnings equate to sober and objective analysis of a business
Conducting a quality of earnings check sooner allows the buyer to truly establish whether the business that they’re looking at is worth pursuing or not. When this process happens sooner, buyers can avoid all of the hassle and expense that comes with going through other stages in the transaction.
Likewise, a quality of earnings check which happens at the outset also minimizes the chances that buyers will ‘fall in love’ with the target firm and its employees, creating narratives as to how the earnings may not be high quality, but that the business is. There’s no avoiding it: A quality business is one which has quality earnings.
Questions arising from quality of earnings will drive the due diligence process
The questions which arise from conducting the quality of earnings check will drive many of the questions at the due diligence process. The adage ‘what can be measured, can be managed,’ applies here: When looking at another company, the most measurable performance that anyone can readily access is their financial statements.
Thus, checking the quality of earnings can lead to questions which otherwise might not arise in the due diligence process. For example:
● Why have net incomes consistently risen despite falling revenues
● Why has a certain inventory accounting standard been chosen
● Which of the firm’s clients are responsible for its rising accounts receivable
The quality of earnings check ultimately forces you to be realistic about what you want
Above all, the quality of earnings check can force the buyer to reflect on where value will be extracted from the transaction. The adjustments made in the financial statements of the target firm can in some cases make managers reflect about how they could drive more quality in the transaction, be it with that particular target or another.
An example of this is how sellers will typically take out the owner’s salary as one of its primary adjustments to the income statement. The buyer then needs to ask whether the owner’s salary is the only realistic adjustment that needs to be made if they leave the company – because in the case of some smaller companies, almost all of the company’s value is in the CEO and not just their salary.
Having a firm grasp on the quality of earnings in a target company not only gives buyers a better understanding of the business, it can also leads managers to questions for the due diligence process that they wouldn’t otherwise ask and ultimately, to ask themselves how their own company will look as a result of the transaction.
Conclusion
No successful transaction is complete without a thorough quality of earnings check, so the sooner this process occurs the better. Checking earlier not only means that time and money are saved by getting to the crux of the issue faster, but also give the option of coming back to the financial statements later in the event that some of the target company’s ‘soft’ issues demand them to do so.
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