By James A. DeLeo, CPA, MBA, MST & Richard Frizzell, CPA, MSA
Gray, Gray & Gray, LLP
One of the most important outcomes of financial due diligence related to a potential merger or acquisition is a quality of earnings report. A quality of earnings report is frequently used by potential buyers and their lenders, as well as investors to more fully evaluate a company’s financial health. It can also be used by sellers to help facilitate buy-side diligence thereby reducing the risk of a change in valuation due to adjustments proposed during the buy-side diligence process.
The quality of earnings report summarizes the adequacy of the various accruals and reserves within the financial statements of the target company. The report typically provides a bridge from net income in the target company financial statements to adjusted EBITDA or earnings before interest, taxes, depreciation, and amortization. In addition, the report will include an analysis of the proposed add-backs to EBITDA by the seller, culminating in adjusted EBITDA that the buyer and their related sources of capital can use to value the transaction.
Companies vary widely in the way they calculate and report earnings. Therefore, a quality of earnings report will typically include an analysis of revenue recognition and, in certain instances, normalizing the earnings of the target. A quality of earnings report attempts to cut through the confusion to present a true and meaningful representation of a company’s cash flow.
Factors that determine earnings quality, and therefore must be carefully identified and evaluated, include:
- Financial reporting practices – How are earnings reported? What accounting methods are used? How are financial statements assembled? How do interim reports match up with annual statements?
- Governance and internal controls – What is the composition of the management team? Who has reporting and oversight responsibilities? What safeguards are in place against fraud?
- Company characteristics – What are the company’s sales trends? How do they compare to competitors and to budget? Is the company growing? Is the industry growing or mature?
- Audit quality – Does the company’s audit firm have adequate experience? Are audits thorough and detailed? Are there any management comments resulting from the audit?
- External factors – What is the company’s tax position? Are any legal issues looming? Is the business subject to geopolitical influences?
All of these considerations must be included in the examination and analysis of earnings in order to derive a true and meaningful analysis.
Included in all of our quality of earnings reports is an analysis of the working capital requirements for the business as well as a preliminary tax review. A user of this report will consider this information when determining the working capital target for the transaction and the tax status of the company for sale.
No two quality of earnings reports should be the same. The content of each report should vary depending on the needs and requirements of the specific buyer. These needs will change based upon whether the transaction is for the purchase of assets or stock, and whether the buyer is financial or strategic in nature. Care must be taken at the outset of a transaction to tailor an approach to diligence to ensure the contents are useful to the intended users and provide value to buyers and sellers alike.
James DeLeo and Richard Frizzell champion the Transaction Advisory Services Practice Group of Gray, Gray & Gray, LLP, a business consulting and accounting firm located in Canton, MA. (http://www.gggllp.com/)