What is the value of my business? What’s the right sale price? What data do I need to present to justify that price? From a buyer’s perspective, what’s the right acquisition price? Is the company as financially sound as it appears?
A Quality of Earnings assessment is the due diligence performed by an accounting firm to paint a clear, accurate picture of a company’s financials and value, with an emphasis on EBITDA (earnings before interest, taxes, depreciation, and amortization). This involves analysis of deeper financial details that a buyer or seller might not see when reviewing financial statements. A Quality of Earnings assessment also shows how a company accumulates its revenues and can set realistic expectations of future earnings, which can have a direct impact on a company’s valuation.
This information is used for negotiations and structuring of deals in mergers and acquisitions (M&As). Companies will often have an audit, but an audit doesn’t provide the most accurate snapshot of the company’s value proposition from either the sell-side or the buy-side. A set of audited financials may effectively illustrate one or two key metrics, but it typically lacks a meaningful summary of value in terms of macro and micro-economic data.
A Quality of Earnings assessment, on the other hand, will provide a full cash proof over revenue, generally from one to three years or the latest data for the targeted metric. Essentially, a very exhaustive analysis will show if revenue passes muster. Is your data verifiable to cash receipts? If not, why? This is the first big test from a quality of earnings perspective.
In most cases, a modified accrual basis is also shown. For EBITDA, accounts receivable and payable are included in the balance sheet with specific adjustments required to the P&L to arrive at that number. Findings are summarized in a top-to-bottom report that also includes industry data, which provides both the sell and buy-side with a reliable, accurate snapshot of revenue, EBITDA, pre-tax income, and other metrics, including all relevant add-backs. A quality of earnings assessment could uncover instances of companies overstating cash and revenue. In other cases, it could expose flat-out fraud.
A Real-World Example of the Impact of Quality of Earnings
A quality of earnings assessment was put together for a large medical company looking to buy a medical transport business with more than $4 million in revenue. The cash proof was almost too clean, right down to the dollar, raising suspicion.
The cash statement didn’t look like it came from the bank. Many of the cash deposits were in different forms. Signs on negatives became positives and debits became credits. When the seller was asked to pull bank statements in real-time, they immediately fessed up to fabricating the bank statements to complete the sale.
This is a somewhat rare case, however, as financials are more commonly distorted by unintentional mistakes and human error, not deliberate attempts to mislead or deceive. Regardless of how it happened, you need to understand the true value proposition based on accurate data.
How Prager Metis Can Help
Prager Metis’ CFO Advisory Services Group is equipped to compile transaction diligence, including quality of earnings, operational assessments, and value creation analysis. While most companies think they’re receiving these services from their accountants, in reality, they’re not getting the depth of analysis and data clarity that is provided in a comprehensive quality of earnings assessment.
If you’re considering a sale or acquisition and want full confidence in the accuracy of the value being presented, contact us to schedule a consultation
