In mergers and acquisitions, the target’s financial statements may not provide sufficient insight to justify the purchase price. Investors and lenders may request a quality of earnings (QOE) report as part of the due diligence process. These reports can be used to evaluate the accuracy and sustainability of the seller’s reported earnings.
Opportunities and threats
When investing in a private business, historical financial statements are relevant only to the extent that similar results are expected in the future. While financial reporting provides insight into past results, QOE reports help identify internal and external trends that may provide value-building opportunities — or threaten a company’s future performance.
Consider these examples. The founders of Netflix tried to convince Blockbuster Video to purchase their struggling start-up for $50 million in the early 2000s. Blockbuster declined the offer numerous times, because the start-up was unprofitable at that time. Today, Netflix has grown to a market cap of roughly $130 billion by staying focused on market trends. In doing so, Netflix has capitalized on changes in technology and transitioned its distribution model from DVD-by-mail rental to on-demand internet streaming. Perhaps a QOE report might have helped Blockbuster identify and capitalize on these trends.
Instead of choosing Netflix, Blockbuster chose to partner with Enron Broadband Services to launch a video-on-demand service. That deal fell apart in 2002 after news broke about Enron’s scandalous financial statement fraud. Eventually, Blockbuster filed for bankruptcy. Again, a QOE report might have revealed some alarming trends about this joint venture partner.
These examples show how historical results are worthwhile only if they can be used to predict cash flow to investors in the future. QOE reports interpret the target company’s historical results in the context of today’s market conditions. This analysis can help identify trends that may cause future performance to differ from what’s happened in the past.
Risk assessment
QOE reports evaluate the details underlying the target company’s earnings. 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. Examples of operating risks that may be unearthed in a QOE report include:
- 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 issues may derail a deal, QOE reports may also find information that buyers can use to add value after closing. For instance, a QOE report may be used to 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.
Eye on EBITDA
Another important metric that may be evaluated in a QOE report is earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA isn’t audited — and it can mean different things to different people.
In a QOE assessment, 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 may not approximate the amount that the company would need to spend on long-term assets.
Customized reports
The scope and format of QOE reports vary, because they’re not bound by prescriptive guidance from the American Institute of Certified Public Accountants. That means QOE reports can be tailored based on the users’ needs and preferences.
For instance, a potential buyer might notice that a target company’s inventory has increased substantially over the last three years. The seller might explain away the change by attributing it to rapid revenue growth. A skeptical buyer could ask for ratio analysis to dig deeper into the anomaly to determine possible causes. In this situation, a QOE report that analyzes the company’s inventory turnover ratio (average inventory ÷ cost of sales × 365 days) might reveal that the increase is due to poor inventory management practices or obsolete inventory.
What’s relevant depends on the company’s operations and industry. Accounting professionals who specialize in a particular niche can devise a list of ratios that make sense based on the circumstances. Industry specialists also have access to financial benchmarks from trade associations and other external sources. These benchmarks can help buyers evaluate how a target measures up against competitors.
Supplementing the financials
Whether you’re buying or selling a business, or simply looking for ways to improve performance, a QOE report is a powerful tool. It goes beyond historical financial statements to provide insight into the factors that drive value.
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