Obtaining a quality of earnings report is a crucial step in the due diligence process of an acquisition. A quality of earnings report provides quantitative and qualitative insights into your company’s historical financial performance that may affect valuation and cash flow forecasts. Understanding the sustainability of a company’s revenue streams and sustainable earnings is critical during an acquisition, as they directly impact how a prospective buyer might value your business.
Ask yourself these five questions to glean important insight into your quality of earnings analysis.
1. Are historical earnings sustainable?
Oftentimes a target company may try to take advantage of anomalies in the market or unusually strong earnings years. A quality of earnings report should take into account any non-recurring or one-time revenues to give the prospective buyer a better idea of what level of earnings are sustainable post-transaction.
2. Have accounting practices and procedures changed?
Changes in accounting methods and procedures during the historical period analyzed may create anomalies and discrepancies in a quality of earnings report. Both buy-side and sell-side analysts should take into account changes in accounting principles, practices, and procedures so as not to mislead potential investors.
If there have been changes in accounting procedures, it is important to discern why those accounting conventions were changed in the first place. Unexplained changes in accounting processes may be indicative of management’s lack of character or trustworthiness.
3. Are any expenses unusual or non-recurring?
When analyzing expenses in the financial due diligence process, a due diligence provider should always investigate expenses that are both atypically high and atypically low.
Unusual or non-recurring expenses should be removed from earnings before interest, taxes, depreciation, and amortization (EBITDA) so as to present normalized historical earnings and more accurately depict what a prospective buyer can expect going forward.
4. Are there any qualitative observations that a prospective buyer should be aware of?
When performing due diligence procedures, a due diligence provider may come across issues or concerns that fall outside the scope of a traditional quality of earnings analysis. A reliable provider will always “put themselves in their client’s shoes” and make sure to communicate any potential non-financial concerns. Such concerns may include the quality and capabilities of the management team and any external factors that may affect the transaction.
5. Are there any potential contingencies or off-balance sheet liabilities?
Most diligence processes include analysis of any potential legal contingencies or obligations that may arise in the future. In addition to legal contingencies, off-balance sheet liabilities may include unfunded pension obligations or overly burdensome purchase obligations. Our quality of earnings reports always identify contingencies or potential debt-like items that may affect a target’s valuation.
Maxwell Locke & Ritter: Accounting Expertise You Can Trust
For help with your acquisition or divestiture, consult Maxwell Locke & Ritter’s transaction advisory services team. Our firm is proud to provide the requisite expertise and experience, no matter the size and complexity of your transaction. In addition to our audit, tax, and transaction advisory services, our subsidiary firm ML&R Wealth Management is well-equipped to provide you with investment advisory services and corporate retirement plan guidance.
We would be happy to discuss your unique financial goals with you to learn how our team of professionals can best serve you. Contact us today.