CPA conducting financial review

What is a Quality of Earnings (QoE) Report and Why They Matter for Sellers

CPA conducting financial review

 

When considering selling your company, one critical tool often overlooked is a Quality of Earnings (QoE) report. Unlike traditional financial statements, which provide a snapshot of a company’s financial health, a QoE report offers an in-depth analysis of a company’s profitability and sustainability, giving potential buyers and sellers a clearer understanding of the company’s true value. Here’s why QoE reports are essential for sellers and how they can influence a successful transaction.

 

What Is a Quality of Earnings Report?

A Quality of Earnings report examines the validity and reliability of a company’s financial statements. It is a deep dive into the company’s financials, focusing on adjustments to reported earnings to reveal the company’s true operating performance. While not as comprehensive as an audit, it’s a highly targeted review designed to validate recurring revenue streams, uncover hidden risks, and provide a reliable picture of the company’s financial health.

 

For sellers, a QoE report can be a game-changer. By commissioning their own report, sellers gain an advantage when negotiating with buyers, especially private equity firms, which are known for leveraging financial findings during due diligence to adjust purchase prices.

 

Why Sellers Should Invest in a QoE Report

Traditionally, QoE reports have been prepared on behalf of buyers, particularly private equity investors. These reports protect buyers by reducing the risk of litigation from stakeholders if an investment underperforms. However, there’s a growing trend of sellers commissioning their own QoE reports, and for good reason:

 

  1. Strengthen Negotiation Power Buyers often use their QoE findings to reduce the purchase price by identifying discrepancies or overstated earnings. With a seller’s QoE report in hand, you can proactively address potential discrepancies, ensuring that your valuation adjustments are fair and defensible. 
  2. Address Issues Before Going to Market A QoE report conducted before listing your company can uncover potential financial reporting issues. This provides an opportunity to resolve them and present a clean, reliable financial picture to buyers. 
  3. Maximize Valuation Small adjustments to reported earnings can have significant impacts on valuation. For example, if a buyer’s QoE analysis finds that your earnings are lower than reported, the purchase price could decrease substantially. Investing in a $40,000 QoE report upfront could save hundreds of thousands of dollars—or more—in valuation adjustments.

 

What Does a QoE Report Include?

A typical QoE report covers several critical components:

 

  1. Engagement Scope and Business Overview This section outlines the scope of the analysis, including what financial documents were reviewed and any limitations of the study. 
  2. Management Adjustments These adjustments account for one-time or non-recurring expenses, such as COVID-related costs or tax credits, to focus on recurring operational performance. 
  3. Due Diligence Adjustments This includes identifying expenses that may not align with standard operational costs, such as personal expenses run through the company or adjustments for leases. 
  4. Pro Forma Adjustments Rare but impactful, pro forma adjustments reflect hypothetical scenarios, such as how a recent investment might have affected earnings if it had been made earlier.

 

Common Missteps Without a QoE Report

Private equity buyers often use the due diligence process to identify discrepancies in reported earnings. A common tactic: buyers may agree to pay a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), only to “rediscover” during due diligence that EBITDA is lower than reported. While the buyer keeps their promised multiple, the valuation—and therefore the purchase price—drops.

 

Having a QoE report on the sell-side ensures you’re prepared to counter such adjustments with credible, data-backed responses, protecting the valuation of your company.

 

When Does a QoE Report Make Sense?

While QoE reports can be a valuable tool, they’re not necessary for all transactions. These reports are typically more relevant for larger transactions, generally $5 million or more, where the cost of the report is justified by the potential return on investment. For smaller deals, alternative approaches to validating financials might be more cost-effective.

 

Preparing for a QoE Report

The key to a successful QoE analysis is good preparation. Sellers should:

 

  • Maintain Strong Financial Practices: Ensure financial statements are accurate, complete, and regularly updated. 
  • Develop Relationships with CPAs: A CPA who knows your company well can provide invaluable support in preparing for a QoE analysis. 
  • Start Early: Ideally, sellers should begin preparing their financials and engaging with a CPA at least five years before a planned exit.

 

Why Work with DBG Advisors?

Selling a company is one of the most significant financial decisions a business owner will make. With so much at stake, having the right guidance is essential. DBG Advisors specializes in helping business owners prepare for a successful sale, including navigating the complexities of QoE reports and other pre-sale preparations.

 

From ensuring your financials are in order to negotiating fair terms with buyers, DBG Advisors acts as your trusted partner throughout the process. Their expertise in sell-side preparation can make the difference between a successful transaction and a disappointing outcome.

 

Contact DBG Advisors Today

If you’re considering selling your company, don’t leave your financials to chance. A Quality of Earnings report can help you maximize your company’s value, avoid costly surprises, and ensure a smoother transaction. Contact DBG Advisors today to learn how their expertise can help you prepare for a successful sale.