Should Small Business Buyers Use a Quality of Earnings Report?

Summary: Buying a business is the largest financial transaction that most entrepreneurs ever make. However, many entrepreneurs often go into the transaction without key information about the business. This lack of information leaves the buyer at a disadvantage.

Fortunately, a Quality of Earnings (QoE) report can often correct his situation. A QoE report is an essential tool that helps buyers better understand the companies they are acquiring. The report helps identify potential risks before the acquisition, allowing you to adjust your offer accordingly. In this article, we cover the following:

  1. What is a Quality of Earnings report?
  2. What is included in a QoE report?
  3. What are the report's advantages?
  4. What are the report's limitations?
  5. Should you get a QoE report?

1. What is a Quality of Earnings report?

A Quality of Earnings report is an essential tool for entrepreneurs looking to buy an existing business. The report is written by a financial professional after a detailed evaluation of the target business. Its ultimate goals are to help you find potential problems and determine if the company's revenues are sustainable after the purchase.

Buyers typically use these reports during the due diligence phase of the acquisition. These reports serve several purposes. They can help you:

  • Develop realistic financial forecasts
  • Validate key assumptions
  • Identify hidden risks
  • Negotiate price adjustments

a) Small business acquisitions

QoE reports are typically used in midsize and larger acquisitions. However, they are not as common as they should be in smaller acquisitions. This situation leaves buyers vulnerable to acquiring a troubled business.

We think that not using a QoE report is often a mistake. Consider the following scenario. Most businesses with a price under five million dollars don't keep accurate accounting. Consequently, they cannot provide reliable financial statements. The fact that the business's financial statements may be unreliable should be another reason to be cautious during due diligence.

Even if the company provides adequate financial statements, these statements don't give you a complete picture of the business. Why should entrepreneurs rely on these reports for the largest transactions they will ever make? This is where the QoE comes in.

2. What subjects are covered in the QoE report?

These reports are typically conducted by CPA firms. However, they are not standardized and may be conducted by other financial professionals. Most reports cover some or all of the following subjects.

a) Sustainability of earnings

In our opinion, this is the most important metric the report covers. It gives you an idea of the likelihood that the current earnings will be sustained into the future. Keep in mind this is an estimate rather than an iron-clad guarantee.

b) Accounting issues

This section lets you know if the company has any serious accounting issues. This insight gives you an idea of the reliability of the financial statements. There are several types of issues that may appear in this section. These include inventory valuation, revenue recognition, etc.

c) Concentration issues

The section details any customer or supplier concentration issues. Concentration issues are a serious risk for any business since they leave the business in a vulnerable position.

A company whose revenues depend on a few key clients could be severely impacted if a single client leaves. Furthermore, this situation could put the business into a financial tailspin.

Supplier concentration also presents a serious risk. These companies depend on a few key suppliers. Issues with a single supplier could affect the whole business.

d) Financial anomalies

"Financial anomalies" is a "catch-all" term for revenues and expenses that don't happen during the normal course of business. These items typically include one-time revenues and expenses.

Consider the following situation. The company makes a very large sale with little chance of repeating in the foreseeable future. This sale has a positive impact on the company's earnings. However, it is not representative of future earnings. You must account for this anomaly in your projections and purchase offer.

e) Related-party involvement

Related-party involvement typically refers to situations where a family relationship is involved in the company's operations. More generally, related-party transactions occur when the business gets preferential treatment from clients or vendors due to personal or business connections.

Consider the following two situations. Assume a business gets a discount on its rent because the landlord is the owner's father-in-law. Or, assume a key client is a company owned by the current owner's best friend. Would these transactions continue on their current terms once you assume ownership?

Knowing about these relationships is important because the preferential treatment may not continue once you acquire the business. A change in these relationships could impact your operations and profitability. Consequently, they must be accounted for in your offer.

f) Recent changes

This section covers any recent changes that could affect the business. These changes could be positive or negative but could affect the company's bottom line.

Consider the following example. The company recently hired a general manager or added a new team of employees to handle near-term business growth. These changes could be important and will affect the business. However, they wouldn't be reflected on the company's financial statements.

g) Unusual benchmarking

You need to know where the target business falls in relation to industry benchmarks. A business that performs below its industry benchmark is an obvious cause of concern. However, a business that performs substantially well above its benchmark should also be a cause for caution. While this performance may initially look great, you should investigate further to understand this discrepancy.

3. What are the advantages of a QoE report?

We believe a well-written QoE report developed by a professional with experience in small acquisitions is valuable. Here are some important benefits.

a) Are your assumptions correct?

The report provides a detailed analysis of the business you are about to acquire. It provides a good idea of the company's ability to sustain and grow current revenues. You can use this information to validate your assumptions and adjust your forecasts.

b) Should you walk away?

Sometimes your best investment is the one you avoid. A good QoE report can identify serious undisclosed risks that impair the company's value or future viability. Consequently, you can use it to build a legal justification to walk away from a misrepresented transaction.

Note: Working with a qualified attorney with experience in small business acquisition is important. Otherwise, you could end up exposed to severe liabilities.

c) Pricing negotiations

In most small business acquisitions, the pricing provided in the Letter of Intent (LOI) is based on the buyer's initial due diligence of the business. However, that due diligence is only high level. The final offer is often negotiated while drafting the purchase agreement.

The QoE report provides a comprehensive view of the target company. Information that impairs the company's valuation can be useful in determining if your offer must be renegotiated.

d) Determine a reasonable SDE

The QoE report can provide information to adjust the Seller's Discretionary Earnings (SDE) to a realistic level. The SDE calculation is key for many small business acquisitions. Sellers and buyers typically use a multiple of the company's SDE as a validation guideline. Consequently, a change in SDE may change the business's value.

e) Add-backs

Add-backs are revenues and expenses added to final financial reports. They are typically negotiated during the due diligence phase. The QoE can help you identify expenses that should be added back or revenues that should not. These additions or subtractions affect the SDE, ultimately affecting the company's valuation.

4. What are the limitations of the report?

Quality of Earnings reports are not perfect, nor are they all-encompassing. The reports have some limitations that buyers need to consider.

a) They are expensive

Quality of Earnings reports can be expensive relative to the cost of the business you plan to acquire. This cost is one of the reasons they are less common in small business acquisitions. Furthermore, a positive report does not guarantee you are buying a good business.

b) Examiner's experience

The quality and usefulness of the report depend on the experience, training, and thoroughness of the team doing the due diligence. A report developed by an inexperienced team may not be as valuable as you had hoped.

c) Inaccurate information

The reports are developed using the seller's financial reports. Unfortunately, small business owners don't have the best accounting practices. This limitation affects the quality and reliability of the information they provide.

A good firm may be able to adapt the seller's financial reports to adjust for improper accounting. However, this does not guarantee the information is completely accurate.

d) Limited information

The examiner needs access to reliable information. Information comes from several sources, including the seller, industry databases, etc. However, the examiner may not have access to all needed information. This situation may happen simply because the seller omits it, the information is low-quality, or is not generally available.

5. Should you get a QoE report?

We believe a Quality of Earnings report is an essential tool for many small business buyers. However, the size of the transaction plays an important role in the decision. A small transaction may not warrant the expense and effort of developing a report. Ultimately, you must decide if you want one based on your available funds and risk tolerance.

You also need to find the right financial advisor to perform the examination. Otherwise, the report won't be as valuable as it should be. Seek an advisor with experience evaluating businesses similar to the one you are acquiring. Also, examine the advisor's credentials carefully.

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Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.

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