A quality of earnings report is used when buying or selling a company to shed light on the state of a business. It seeks to quantify a company’s financial position by breaking down its financial information to show trends. These reports often are initiated by a business owner in an effort to prepare themselves and their leadership team for the challenges of the sale process.
“Management must be prepared for the barrage of questions they’re likely to get from potential buyers,” says Spencer Helwig, CPA, a supervisor at Corrigan Krause. “Not having an answer to any one of them can lead to tough conversations, added time and cost to figure out the answers, and sometimes unwelcome discoveries.”
Smart Business spoke with Helwig about quality of earnings reports — what they accomplish and why they’re important to those considering the sale of their business.
What’s involved in the quality of earnings report process?
The quality of earnings process often begins with conversations about operations. Then the team responsible for the report requests information, performs an analysis and begins lengthier conversations with company leadership regarding trends.
The initial analysis looks to define normal recurring business expenses versus non-recurring expenses, which it will highlight in a narrative for potential buyers. For example, a company’s shipping costs likely skyrocketed in 2021 and 2022, but are now coming back down. Without a proper narrative, informed by questions asked during the development of the quality of earnings report, 2021 and 2022 can look like poor-performing years when, in reality, the company was affected by outside, non-recurring circumstances. That adjustment can be calculated and explained to shed light on what happened and what is expected for the business moving forward.
A quality of earnings report also can be an important part of assembling the data room that buyers will explore. Much information is requested during the process — invoices to better understand certain adjustments, a look at billing processes.
A quality of earnings process can expose issues that management might not be aware of or didn’t understand their extent. This gives management a chance to fix these issues before buyers see it and prepare for any question a potential buyer could throw at them.
What value does the quality of earnings offer buyers?
A quality of earnings report can be a good start to building the data book and starting the sale process, but it won’t provide what every buyer wants. Each buyer is likely to request additional information based on how they view the value of the business and run their own diligence process. Having a quality of earnings done by the seller tends to speed up the buyers’ diligence process because that groundwork has already been laid — most of the questions have been asked and answered, so much less time is spent running reports. Buyers also tend to gain confidence when they see a thorough data book, a diligent analysis of key information and a narrative that will shed light on the trends that might not be apparent in the financial statements.
What should companies expect from the process?
The process typically takes between three to five weeks, depending on the size and complexity of the business. There are lengthy conversations to help explain the findings and uncover things that otherwise might get buried in a normal financial statement. In cases where the CEO is the person who has the best understanding of what’s happening in the business, a quality of earnings process could be demanding of their time. Ideally, a company has a leadership team that is fully aware of what’s going on so the workload doesn’t fall so much on one person.
Quality of earnings report are best done by reputable providers with a financial background, a history of performing analysis and experience dealing with companies of similar size and type of business.
These reports are a great piece to help business owners and management understand their business. They lay the groundwork for the many buyer conversations leadership will have once the selling process is underway, and help teams avoid uncomfortable surprises that could negatively affect value. ●
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