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What is the quality of your earnings?

You might have heard that buyers often do a quality of earnings analysis.

Lets take look at what quality of earnings really means, how buyers do this analysis and how you can prepare for it.

Earnings for previous periods are recorded on profit and loss statements, but buyers like to get inside and breakdown the revenues and costs that create them and assess each component on its likely future value. Because earnings multiples are often used as a valuation measures, buyers want to know whether future earnings will trend in the same way as old earnings have.

We have all heard the stories of buyers who take over a business, only to find that revenues plummet, costs increase and the profitability they thought they would enjoy never eventuates.

Quality of earnings (QoE) analysis seeks to uncover many of the follow issues:

a) whether

b) whether revenues have been impacted by one-off events;

c) whether the business is over reliant on a large customer;

d) whether variable costs, under new ownership, change;

e) whether and how might fixed costs be understated;

f) whether tax conditions under a new owner will result in a material change in financial performance

g) whether balance sheet liabilities are complete and reasonable etc.

A buyer’s due diligence team will pour over your numbers, develop a 3-way spreadsheet, delve deeply into the business’s sources of revenue and determine if the cost base can be repeated in following years.

You can of course respond to QoE questions as they arise and tie up your whole team. And when you have multiple buyers in DD being tied up often brings the deal to a stand-still, causing less patient buyers to exit the process.

Its best to put the work in to prepare the due diligence material beforehand including answers to likely dd questions. Not only will this help save due diligence time, but it more importantly means that you and your M&A advisor are more likely to be able to enforce a response timetable from your buyers, putting you in a stronger negotiation position.

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