The Importance Of A Quality Of Earnings Report In M&A Transactions

Opportune LLP
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Find out why a quality of earnings report is vital for the due diligence of M&A transactions or investing in a business.

A quality of earnings report from a respected industry expert provides an extra level of certainty during a buyer’s due diligence process around an acquisition, or alternatively, gives sellers a third-party party view of potential red flags, issues, or areas of concern from industry outsiders that they can work to clean up to ensure they enter a marketing process at the best time to maximize value.

READ MORE: Top 5 Tips When Converting Business Associate Data In Oil & Gas Transactions

For buyers, a well-done quality of earnings report is more than just a rubber stamp to present to investors or internal compliance to sign off on a deal. A quality of earnings report provides valuable insight into historical operations and areas to highlight or areas of concern for the go-forward business. For sellers, a well-done quality of earnings report allows a third-party to peek under the hood of their business as if they were a potential buyer to point out inconsistencies with financial data, areas of concern, items to highlight, and processes to improve to better position the seller to maximize value on a sale in the open market.

Once cleaned up, a quality of earnings report for sellers provides potential buyers an extra level of comfort during their diligence process that the financial information they are reviewing has been vetted by a third-party party.

Some of the key procedures in a quality of earnings are presented below:

  • Reconcile historical earnings before interest, tax, depreciation, and amortization (EBITDA) to the annual income statement and interim results.
  • Understand and evaluate management adjustments to reported EBITDA.
  • Examine tax filing positions and reporting.
  • Analyze monthly revenue and gross margin.
  • Recalculate project-level revenue and savings to verify project economics.
  • Analyze run-rate for latest trailing 12-month (TTM) and/or year-to-date (YTD) results, adjusted for pro forma impacts; compare to budget and cash flow forecasts.
  • Discuss concentrations of customers, credit risk, and any deductions from gross sales.
  • Cash flow analysis (i.e., EBITDA vs. operating cash flow and intra-month cash balances).
  • Summarize historic working capital fluctuations and patterns from January 1, 2020, through the date of the latest available balance sheet (e.g., 9/30/21).
  • Review material contracts for concerns.
  • Inquire as to the existence of off-balance sheet liabilities and assess based on contract review.

A quality of earnings report detailing any findings or issues uncovered through undertaking the above procedures is an important part of the M&A due diligence process and shouldn’t be overlooked.

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