How to Determine Quality of Earnings

how to determine quality of earnings

Before buying or selling a business, parties on both sides descend into a whirl of numbers, digging deep to determine a fair valuation. The value of any company will be determined by placing a multiple on the EBITDA, or earnings before interest, taxes, depreciation, and amortization.

The EBITDA isn’t the final word, however, as buyers and sellers frequently look at those numbers even more closely by performing a quality of earnings study. Understanding how to determine quality of earnings will help ensure that the valuation being presented is fair and realistic.

What Is “Quality of Earnings”?

A quality of earnings study, or QofE, helps provide an understanding of the quality of a company’s financials and corresponding earnings power. It’s an excellent way for a potential buyer to “kick the tires,” so to speak, and ensure that the EBITDA numbers that are being presented are valid.

More and more, sellers are taking the initiative to have QofE studies performed in advance of selling their businesses. Doing so helps them better control the narrative before getting in front of a buyer. With QofE numbers in hand, a seller can identify any potential risks up front. This reduces the chance of them getting in the midst of buyer due diligence and facing uncomfortable questions about unexpected errors discovered in the financials.

How to Determine Quality of Earnings

During a sale, the overall valuation of a company will be based on an adjusted or pro forma EBITDA that will be accurate for the company post-sale. Add backs and adjustments can help reflect the EBITDA on a normalized go-forward basis. These items include one-time expenses, as well as non-recurring expenses that won’t carry forward under new ownership. These adjustments can include things such as excessive owner compensation, excessive bonuses and benefits, reserve estimates, vacation accruals, and one-time professional fees, services, or equipment purchases.

In addition to specific items, you may also look for historical trends to see if there are particular expenses that stand out as possible adjustments. There may be a specific expense that was recurring over the period of a year but did not continue on a go-forward basis. All of these items can greatly increase a company’s EBITDA, but more importantly, they help provide an accurate view of the normalized cash flow.

When conducting a QofE study, accounting experts will analyze all of these adjustments to determine their legitimacy. They will also be on the lookout for additional adjustments that need to be made.

How to Avoid Fluctuations in Quality of Earnings

In order to avoid questions about the QofE, a company should strive to have good financials — preferably audited financial statements, but you should have financials that have been reviewed, at the very least. The financials should provide an accurate picture of the policies and procedures of the business, its accounting practices, and how it’s currently being run.

It’s also essential to run your business as cleanly as possible. This will make things much easier when you decide to sell. The more transparent you are in your financial records, the easier the due diligence process will be.  

While MelCap Partners doesn’t perform QofE studies, we advise our clients to work with a good accounting firm that has a strong transaction advisory background. They can help you identify which add backs and adjustments are valid and which ones look questionable and either need more support or should be removed.

QofE is about assessing risk and ensuring that the EBITDA both parties are basing the purchase price on is valid. While historically performed on the buy-side, over time, sell-side QofE diligence is increasingly becoming a trend. And why not? With the right numbers in place and the proper analysis to back them up, QofE means that your M&A transaction has more certainty of closing.

By Al Melchiorre

Al founded MelCap Partners in 2000, and is responsible for managing all aspects of client engagements from proposal through closing, developing business, reviewing offering memorandums and financial models, negotiating purchase agreements, and interacting with buyers and investors.