Audited financial statements provide valuable insights into your company’s historical financial performance. However, because these reports focus primarily on compliance with U.S. Generally Accepted Accounting Principles (GAAP), they may have some limitations. Notably, profits reported on your income statement may not fully capture the company’s ongoing earning power. For example, a significant one-time project may temporarily boost profits, or short-term adverse market conditions may result in understated earnings.
In such situations, a quality of earnings (QOE) report can supplement your financials and help determine whether a company’s earnings are recurring and reliable. A normalized earnings picture can be useful when identifying operating strengths and weaknesses, merging with another company, or evaluating other strategic decisions.
Internal uses
QOE reports can help management interpret the company’s historical results in the context of today’s market conditions. These reports separate core operational income from nonrecurring or nonoperational items (such as one-time gains, discontinued operations, or unusual expenses). They may also delve into the components of the company’s earnings in greater detail. For instance, gross profits may be broken down by geographic region, salesperson or product line to understand what’s making money — and what’s not.
QOE reports help identify internal and external trends that may provide value-building opportunities — or threaten a company’s future performance. Management can use these reports to guide investment decisions. They can also identify operational flaws, such as inconsistent accounting policies, weak controls, unusual accruals or adjustments, and revenue or expense timing issues. By addressing these findings proactively, management can enhance the reliability of the company’s financial reporting.
External uses
In mergers and acquisitions (M&As), potential buyers may use QOE findings when evaluating the seller’s GAAP financial statements. In addition to providing insight into the company’s true earning potential, QOE reports may help reveal potential deal risks, such as:
· Customer or supplier concentration risks,
· Seasonal cash or human capital shortfalls,
· Deferred equipment purchases and maintenance,
· Bad debts,
· Obsolete technology,
· Dependence on a key person,
· Capacity constraints,
· Undisclosed related-party transactions,
· Pending litigation,
· Emerging competition and substitute products, and
· New government regulations.
While these due diligence concerns may derail a deal, QOE reports may also find information buyers can use to add value after closing. For instance, a QOE report may help identify revenue-building or cost-cutting synergies with a particular buyer that may warrant a premium above market value or the seller’s asking price.
Another important metric that a QOE report may evaluate is earnings before interest, taxes, depreciation and amortization (EBITDA). This metric isn’t audited — and it can mean different things to different people. In a QOE report, EBITDA is typically adjusted for such items as owners’ compensation and other discretionary spending, nonrecurring revenue and expenses, and accounting methods that differ from industry norms. It’s also important to recognize that depreciation and amortization don’t always represent the amount the company would need to spend on long-term assets.
Reap the benefits
Whether you’re buying or selling a business, or simply seeking ways to improve performance, a QOE report can be a powerful decision-making tool. You can tailor its scope and format to your specific objectives. Contact Hood & Strong to discuss how a customized, independent QOE report can help you make confident, data-driven decisions that enhance value.
