It is crucial to completely understand the company’s finances before purchasing a business or combining it with another one that already exists. Acquisitions and mergers are not decisions that can be taken lightly, and there is a need for due diligence and proper business valuation so that the buying company can rest assured that the price they are paying is worth the business they ultimately end up buying.
Before a business acquires another business, there is a process of due diligence carried out. One very important aspect of due diligence is the Quality of Earnings (QoE) Report. Read ahead for a more detailed understanding of why the QoE is needed as part of due diligence, the purpose and scope of the QOE, and how it can ultimately affect the business sale.
The Due Diligence Process
A due diligence process is carried out before an acquisition or merger, and it typically begins with the buying company presenting the vendor with a letter of intent (LOI). The LOI generally lays out the terms of the deal, including an outline of what is purchased – whether it is shares of the company or just certain assets, the purchasing price, the terms of the payment, the date of closing for the sale, and the timeline for the entire sale.
The buyer’s offer is often based on only a preliminary understanding of the vendor’s financial statements. Net income is not a completely accurate picture of the vendor’s financial circumstances and can sometimes be a misleading figure.
For example, a company can have consecutively large net income figures, but if there are also negative cash flows at the same time, then the company is not actually doing as well as the buyer might be led to believe. Therefore, before closing any deal, the buyer would need a lot more information about the vendor.
The process of due diligence involves certain processes like the review of all normalization adjustments the vendor proposes, as well as other potential normalization adjustments, an analysis of sales, supply purchases, employee salaries and benefits, operating expenses, and so on. These processes are carried out by reviewing certain documents such as the vendor company’s financial statements, budgets, EBIDTA normalizations, payrolls, etc.
What is a Quality of Earnings (QoE) Report?
So what exactly is a Quality of Earnings (QoE) Report? The QoE is actually a routine step in the process of due diligence. The report is basically an iterative process that goes over all of the financial and accounting discoveries from the due diligence process and then further refines and analyzes those findings to help the buyer better understand the vendor business.
When the due diligence process is completed with a QOE report, it can offer the buyer the confidence needed to close the deal and acquire the vendor company.
Oftentimes, an independent third party is hired to carry out the Quality of Earnings (QoE) Report. This is usually the same independent party that is hired to carry out the due diligence or a separate party in the case that the due diligence is carried out by the buying company themselves. Lets’ take a look at the purpose of a QOE report, the scope of the report, and what needs to be done in preparation for it.
The Purpose of the QOE Report
To get a better idea of the purpose of a QOE report, we can liken it to the process of buying real estate and carrying out a professional property inspection before buying the property. In the same way, the QoE report is sort of like a financial inspection of a vendor company before it is acquired.
The QOE report is usually used by potential buyers as a part of the due diligence process for two main purposes:
- To confirm using vendor financial statements that the EBDITA amount put forward is correct and accurate.
- To confirm that the earnings reported by the vendor are accurate and represent the real earnings of the company since net income is not always a true representation.
Other than these two main purposes, the QoE can be used to further investigate any financial information put forth by the vendor and confirm that it is all true and accurate and that it correctly represents the financial earnings and value of the vendor company.
The Scope of the QOE Report
A QOE report is not the same as an overall financial audit for a company, and, as such, it has a limited scope. The QOE report is carried out by a third party during the process of due diligence, and the scope of the report depends on the size of the vendor company, what parts or operations of the company are going to be acquired, as well as how thorough the due diligence process carried out before has been.
The financial parts of the due diligence process usually involve going over the historical finances of the vendor company, looking at forecasted finances, analyzing working capital requirements, analyzing EBIDTA add-backs, considering taxation implications, and more. As part of the QOE report, the buying company can expect to learn more about the vendor’s earning capabilities, future profitability, and potential risks to look out for.
Preparation for the QOE Report
Once a scope for the QOE report is agreed upon by the buying company, the vendor company, as well as the third party carrying out the report, the main sources of information and financial documentation need to be gathered for the report.
Some of the documents and information sources required to prepare for the report include the historical financial data of the vendor company for the past five years, the current financial documents, the financial forecast for the next year, documents containing any loan or debt information, and tax returns from the last five years.
How the Quality of Earnings (QoE) Report Can Affect the Business Sale
Beginning with the LOI, the due diligence process is incredibly important regarding business sales, acquisitions, and mergers. The due diligence process ends with the QoE report, which can either support or challenge the original offer in the LOI. Based on the findings of the QOE report, the original offer can be moved forward or reevaluated.
The QOE report is ultimately an objective assessment of the vendor company’s finances and earnings. Once these finances and earnings have been confirmed, the buying company might use these figures to challenge or negotiate the purchase price.
The buying company can use the QOE report as leverage to reduce the EBIDTA amount or reduce and negotiate the add-backs so that the purchase price is essentially reduced, and the buying company has to pay a lower price for the acquisition. The vendor company may have its own objections to these challenges and come forward with its own negotiations based on the findings of the QOE report.
As such, the QoE report can greatly affect the business sale and the final purchasing price of the business. To have a substantial QOE report that can be used to negotiate purchasing prices, many businesses opt to hire professional and independent third-party organizations to carry out the report. An experienced M&A advisor, for example, would be able to better negotiate on the buying company’s behalf and deal with any rebuttals from the vendor company.
How the Seller Can Prepare for the QOE and Minimize Their Risks
In most cases of an acquisition or merger, the buying company is the one to carry out the due diligence process and the QOE report. However, that is not to say that the vendor company – or the seller – cannot do their part in preparing the QoE and helping streamline the process for the buyer or the third party that will carry out the report.
In order to allow for efficient collection of data during the QoE reporting period, the seller can ensure that their financial statements have already been reviewed or professionally audited. This will save the time it takes to carry out professional audits once the sale process has started.
If the selling company is facing certain financial struggles and believe there may be inaccuracies in their financial documentation, they can work ahead of time to prepare their own pre-sale seller QOE report. This report can outline potential issues so that the buyers know what they are dealing with and which particular financial aspects need to be assessed during their due diligence.
Working with a professional M&A advisory team can help the seller prepare for the QOE report and address any potential pre-sale problems and any problems arising during the due diligence process.
N3 Business Advisors – Construction Industry Mergers & Acquisition Advisors
If you are the owner of a company and are interested in expanding your business by buying out or acquiring another company, then N3 Business Advisors can offer you its services relating to mergers and acquisitions. We are a merger and acquisitions advisory firm located in Ontario, Canada. We work primarily with businesses in the construction industry, such as HVAC companies, general contractors, landscaping companies, civil engineering firms, and more.
When it comes to acquisitions, due diligence and Quality of Earnings (QoE) reports, it is often recommended that a company hires an independent third party to carry out the process for them. We’re here to let you know that N3 Business Advisors can carry out your due diligence for you! We have an experienced and successful team that offers many services, such as business sales, business acquisition searches, business valuations, management buy-out, and more. We also offer due diligence support.
With extensive knowledge and experience on the matter, we can add value to any team that is conducting due diligence. We can manage the process entirely on your behalf or just coordinate the exchange of information between you and the selling company.
You can get in touch with N3 Business Advisors now to schedule a confidential consultation. Visit our website for more information, or call us at 647 967 4222. Our office is at 55 Village Centre Place, Suite 200, Mississauga, ON L4Z 1V9. You’re just one step away from getting together an experienced and trustworthy team for your due diligence process and Quality of Earnings (QoE) report.
The Bottom Line
Before buying out or acquiring a company, it is essential for any business to do its part and look into the business they are planning to buy. Due diligence is a very important first step when it comes to acquisitions. The QOE report is the result of an iterative process that goes over all of the financial and accounting discoveries from the due diligence process and then further refines and analyzes those findings to help the buyer better understand the vendor’s business.
Many businesses use the results of the QOE report to challenge or negotiate the purchase price of the vendor company they are trying to acquire. As such, the QoE report plays a very significant role in the purchase and sale of businesses.