How to Get a Quality of Earnings Report [& Why You Need One]
Are you toying with the idea of selling or purchasing a business? Before you go any further in the process, you and any potential investors will want to know one thing: The reality of the company’s financial performance and well-being.
The quickest way to figure that out is with a quality of earnings report. Let’s find out what this report is—and the process to get one.
What Is a Quality of Earnings Report?
A quality of earnings report (also referred to as a QofE, QOE, or financial due diligence report) is an analysis and report of accounting and business records to not only evaluate the accuracy of historical earnings and financial position but also to assist in the identification of any risks or opportunities that may or may not be reflected in the financial statements.
A QofE report is most often used as a form of due diligence to arrive at a basis for a company’s valuation amidst a potential ownership transition, although the report can also be prepared to provide insights to your CFO or financial team.
Once engaged by a prospective seller or buyer, a third party prepares a report that reviews, normalizes, and summarizes a business’ performance for items such as:
- Sources of revenue
- Customer and vendor concentrations
- Non-recurring transactions
- Executive compensation or personal expenses
- Unusual or cyclical trends
- Compliance with U.S GAAP
- Accounting policy changes
- Significant estimates
The QofE report, therefore, attempts to tell the true story of a business’s earnings and financial position and provides insight into prospective performance (i.e. potential for future earnings or risks).
QofE Report versus Audit
It’s easy to confuse the purpose behind a quality of earnings report versus an audit because they are interconnected. The simplest way to explain the difference is this: Audits explain the what of financial statements, while QofE reports explain the why.
A quality of earnings report is a financial analysis that evaluates the quality and reliability of a company’s earnings and profitability. It aims to provide a comprehensive understanding of a company’s financial performance and earnings potential by reviewing key financial metrics such as revenue, operating expenses, and cash flow.
On the other hand, an audit is a comprehensive review and examination of a company’s financial records and operations. The purpose of an audit is to provide an independent assessment of a company’s financial statements to ensure that they are accurate, complete, and in compliance with accounting standards and regulations. An audit is typically performed by an independent auditor who assesses the internal controls, financial reporting processes, and financial statements of a company.
Why Do I Need a Quality of Earnings Report?
The primary reasons to seek a QofE report are to understand your business, prepare for a buy-side transaction, or prepare for a sell-side transaction:
- Understand your business: You should never enter the market blind to the value of either your company or the company you wish to purchase. You may have some projections or estimations of your value, but these shouldn’t be the basis of your price. Getting a QofE report gives you as accurate an estimate as possible so you can enter the market confidently and become aware of any problems in your financials.
- Prepare buy-side: Using your QofE report, a purchasing party can more accurately calculate projections of a business’s future earnings. The report can also reveal how well the two companies will synergize with one another.
- Prepare sell-side: QofE reports ensure your financials are organized enough to initiate a sale. If your report reveals inefficiencies in your business’s revenue cycle, you can correct those issues before entering the market.
Questions Answered in a QofE Report
With a completed QofE report at your disposal, you’re ready to answer the following questions:
- What are the earnings of the business and how are they earned?
- How well-positioned is the company for a sale?
- Are historical earnings sustainable?
- Is your revenue non-recurring or frequent?
- Have your accounting practices changed, and were those changes for the better?
- Are there any off-balance sheet liabilities?
- Do the two businesses have similar customers or vendors (applicable for mergers and acquisitions)?
- What are the cost of goods sold (COGS) (if applicable)?
- What are the potential risks of purchasing the business?
- What are the potential future earnings?
- Are there any deviations from GAAP standards?
How Long Does It Take To Get a Quality of Earnings Report?
The amount of time required to complete a quality of earnings report correlates with the complexity of the sale and the size of the company.
For smaller companies, QofE reports can be delivered within 1–2 weeks depending on the accuracy and availability of current financial figures and supporting documentation.
For larger companies, it can take 1–2 months to complete the entire QofE. This depends on numerous variables, including the complexity of the organization’s inventory, related party transactions, and management’s proposed adjustments.
What Information is in a Quality of Earnings Report?
A quality of earnings report generally covers four major categories: quality of earnings, financial statements, financial performance, and working capital. Within these sections, the following information is revealed:
- Adjusted EBITDA: This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The EBITDA is often considered the “real” income of a company after deducting and adjusting for these considerations.
- Recast Income Statement Analysis: This goes over measurements such as percent of total sales and year-over-year fluctuations.
- Recast Balance Sheet Analysis: This discusses current assets, liabilities, long-term debt, and other factors that impact the company’s financial performance.
- Proof of Cash: This compares the cash deposits recorded on bank statements to the cash collections reported on financial statements.
- Net Working Capital: This measures a company’s liquidity and short-term financial health, calculated as the difference between current assets and current liabilities.
Can This Information Come from My Accounting System?
All the above information can be pulled from your accounting system—as long as that system is accurate and up-to-date. Additional information may be needed from the client such as access to bank statements, payroll, invoices, contracts, etc.
If you’re not sure your financials are up to snuff, using a fractional CFO can be paramount in verifying your organization’s readiness for a merger and acquisition. A qualified CFO can get your financials in order and thereby produce an accurate quality of earnings report.
What’s the Process of Getting a Quality of Earnings Report?
While many variables determine the nitty-gritty details, every process generally follows the same four steps when working with Amplēo.
1. Engagement Letter
When a company is interested in getting a QofE from Amplēo, they will be sent an engagement letter that specifies the entities that will be covered, the analysis period, and the diligence procedures and pricing. Once the engagement is signed, our team will send the client a diligence request list.
2. Diligence Request List
To lay the groundwork for the upcoming QofE report, Amplēo will send out a diligence request list to go over some high-level details with the selling company. This looks at how the company was established, its operations, and how it generates revenue. If the company allows, we’ll also access its financial systems to pull financial records to ensure the QofE report meets the highest level of detail.
With the diligence request list in tow, we can start our analysis. This involves looking at income statements and balance sheets to discover any unusual fluctuations or other concerning variables. Amplēo may reach out to the company’s management if anything concerning arises during the analysis. The management may also communicate any adjustments they wish to propose during this interaction.
4. Report Delivery
While reports come in many forms, Amplēo compiles all of our findings into the following sections.
- Executive Summary: Information regarding the company’s background and systems while summarizing the key findings.
- Other recommendations around accounting policies/procedures
- Quality Of Earnings: Overview of the company’s EBITDA net income and a discussion of adjustments and other considerations.
- Financial Statements: Analysis of income statements and balance sheets.
- Financial Performance: Information regarding the company’s proof of cash and cash collection processes.
- Working Capital: Discussion of trends and unusual fluctuations surrounding working capital
- Appendices: A summary of the scope of the company’s processes and monthly adjustments to EBITDA.
Our reports typically range from 25-50 pages depending on the size of the Company and the scope of diligence work requested.
Get Your QofE Report with Amplēo
You must be proactive when seeking to sell or purchase a company. You want to put your best foot forward when you enter the market, and Amplēo can help you get your footing with our QofE reports.
If you’re ready to get a Quality of Earnings Report, reach out to Amplēo today.