What is a Quality of Earnings Analysis?
- February 7, 2023
A quality of earnings analysis, also known as a ‘QofE’ analysis, is an essential component in a due diligence process. The overall intent of a QofE report is to objectively present the accuracy and reliability of a target company’s reported historical and current financial performance for a potential transaction.
A QofE analysis aims to help both seller and buyer understand the current state and quantity of the target’s economic benefit streams, in most cases represented as earnings before interest, taxes, depreciation, and amortization (EBITDA), which drive the pricing of the transaction.
A QofE analysis assesses the quality and sustainability of the target’s earnings via a thorough examination and analysis of the target’s financial statements and operational data. Normalized EBITDA is derived after adjustments which generally fall into the following categories.
Due Diligence Adjustments
These adjustments may include one-time, non-recurring expenses, out-of-period revenues and expenses, non-business or discretionary expenses, accounting errors, related-party transactions, unreported or underreported liabilities, and owner/executive compensation.
For targets on cash basis accounting, which is typical for privately held small businesses, cash-to-accrual adjustments will also be made to their revenues and expenses to reflect the target’s true economic profitability and cash flow generating ability.
Pro forma Adjustments
Pro forma adjustments are generally made to normalize the trailing twelve months’ (TTM) performance to account for changes that occurred during the year or immediately thereafter to present the performance of the target as if the new situation or scenario occurred from the beginning of the TTM. Examples of these scenarios include discontinued operations, the addition of a new service line, and material reimbursement changes.
A QofE analysis can be performed by either the seller, in which case it is called a sell-side QofE, or by the prospective buyer, in which case it becomes a buy-side QofE. While the QofE procedure and content of it would be similar, the use and purpose of the QofE could serve different purposes and uses.
Prospective buyers rely on QofE reports to ensure that they make well-informed investment decisions. Buyers utilize QofE reports to evaluate the potential transaction, negotiate deal terms, and discover potential red flags or areas of concern associated with the target.
In contrast, buy-side QofE helps the owner/seller understand the business from the perspective of a potential buyer or investor. Generally, sell-side QofE analysis is performed before soliciting buyers to best prepare the target for entering the market. The primary purpose is to allow the owner/seller to solidify the value of the business by proactively addressing any issues that may negatively impact the company’s value.
Coker Group’s financial services team assists healthcare entities with buy- and sell-side QofE analysis. Contact us today to speak with our experienced financial consultants and see if a QofE analysis will meet your needs.
Yong Zhang, CPA, ASA