Quality of earnings
What is a quality of earnings report?
A quality of earnings report tests whether a company’s reported earnings reflect what the business actually earns on a sustainable basis. It normalizes EBITDA by identifying, quantifying and documenting every adjustment, so a buyer, a lender or an investment committee can see exactly where the final number came from and decide whether they believe it.
It is the standard basis for pricing a private company acquisition. If a purchase price is a multiple of EBITDA, the quality of earnings report is the document that establishes what EBITDA actually is.
What is inside the report
A quality of earnings report is not a summary opinion. It is a working document, and the sections do different jobs.
Notice to readers
States what the engagement is and is not. A quality of earnings engagement provides no assurance opinion and is not an audit. This appears on the first page, not buried at the back.
Executive summary, written as points of interest
A plain list of what we found and what each finding means for the price. This is the section your investment committee will read.
Quality of earnings
The core exhibit. Management’s proposed adjustments, each tested against supporting documentation, plus the adjustments we identified ourselves. Every line is quantified and sourced. Presented across three periods: the two prior fiscal years and the trailing twelve months.
Proof of cash
Bank statements reconciled to the books, with receipts and disbursements tested separately rather than netted. If reported revenue cannot be tied to money that actually arrived, nothing built on top of it is reliable.
Income statement analysis
Revenue trends, customer concentration, seasonality, gross margin by segment or product line, and payroll reconciled from the provider’s reports to the general ledger.
Balance sheet analysis
Accounts receivable aging and collectability, accounts payable tested for completeness, related party transactions and whether they are at arm’s length, inventory obsolescence where relevant, and the split between maintenance and growth capital expenditure.
Net working capital peg
The normalized level of working capital the business needs to keep operating after close, calculated cash-free and debt-free.
Summary of deal risks
What we would want addressed in the purchase agreement.
What it actually finds
The adjustments that move a purchase price are rarely exotic. They are ordinary things that nobody has had a reason to look at closely.
Owner compensation, the most common
- Paying below market and leaving at close, so the buyer inherits the cost of replacing them, and that cost belongs in normalized earnings
- Paying above market and adding the difference back, which is legitimate, but only for the portion that is actually above market
People and personal costs
- Family members on payroll at rates that would not survive a job posting
- Personal vehicles, travel and meals inside operating expenses
Things that flatter EBITDA
- One-time items that turn out to happen every year
- Capital expenditure expensed rather than capitalized, which hides a real cash requirement
- Deferred revenue, which in smaller companies is frequently not on the balance sheet at all
- Bad debt estimates nobody has revisited since they were set
None of these are accusations. The point of the exercise is translation, not blame.
Most owner-managed businesses are run for tax efficiency and family circumstance rather than for sale, and the accounting reflects that.
The working capital peg, in plain terms
This is where buyers most often lose money after signing, so it deserves its own explanation.
Most purchase agreements assume the business is delivered with a normal level of working capital. “Normal” has to be defined as a number, and that number is the peg. Deliver less and the buyer funds the shortfall out of pocket after close. Deliver more and the seller has overshot.
Setting it properly means understanding how quickly the business collects, pays and turns over inventory, which is the cash conversion cycle. It also means choosing the right benchmark period. The trailing twelve months smooths seasonality but hides recent deterioration. The last ninety days catches current reality but can be distorted by one large invoice. We test against both, and against the two prior fiscal years, and we tell you which we think fits the business and why.
And the items that reduce what you are really buying
Accrued bonuses. Deferred revenue. Off balance sheet leases. Contingent liabilities.
Debt and debt-like items are listed out, because each one comes off the value of what changes hands.
Not sure whether you need a full engagement?
Send the letter of intent. If the answer is that you do not need one, we will tell you that rather than scope the work anyway.
When you need one
You need a quality of earnings report when the price depends on the earnings figure and the earnings figure has not been independently tested. In practice that means:
- You are buying a private company and the price is a multiple of EBITDA
- A lender requires diligence before committing debt to the transaction
- You are selling, and you want to find the problems before a buyer’s advisor does
- An investment committee needs support for a recommendation
- Management’s adjusted EBITDA schedule exists but nobody has traced the adjustments to source documents
And when you probably do not
An asset purchase priced on the assets themselves, or an entity with recent audited financial statements where the adjustments in question are few and simple. We will say so if that is what we find.
There is no benefit to us in selling work that does not change your decision.
How is a quality of earnings report different from an audit?
An audit provides an assurance opinion on whether historical financial statements are presented fairly under a defined reporting standard. A quality of earnings engagement provides no assurance opinion at all. It is investigative work aimed at one specific question, which is what the business sustainably earns and what a buyer should pay for it. The two also look backwards differently: an audit tests whether the statements are right, while a quality of earnings asks what the statements would look like under new ownership. Treewalk does not perform audit or assurance engagements.
Can I rely on the target’s audited financial statements instead?
Audited statements tell you the historical numbers are fairly presented. They do not tell you what the business earns on a normalized basis under a new owner, which is the number the price is built on. Audited statements are a useful starting point and they usually shorten the work, but they answer a different question.
At what point in a deal should the work start?
Immediately after the letter of intent is signed, and the LOI itself is worth reviewing before it is. Once price and structure are agreed in writing, renegotiating on diligence findings is possible but costs goodwill at exactly the moment you need the other side cooperative.
How long does a quality of earnings take?
It depends on the state of the target’s records far more than on its size. A company on accrual accounting with clean monthly closes moves quickly. A company on cash basis with manual journal entries takes longer, because the first task is restating the financials onto a basis that can be analyzed at all. We give you a timeline after seeing the LOI and the data room rather than quoting one blind.
Who pays for it, the buyer or the seller?
Usually the buyer, as a transaction cost. Sell-side diligence is also common, where an owner preparing to sell commissions the work themselves in order to find and fix problems before a buyer’s advisor finds them. That protects the price rather than defending it.
What do you need from us to start?
The LOI, access to the data room, and an introduction to whoever prepares the target’s financial information, usually the external accountant or the internal controller. Early conversations with the people who actually made the entries save more time than any document.
Send us your LOI. We will review the purchase price.
A buyer with a signed letter of intent has already agreed a number. This tells you whether that number survives contact with the accounts, before diligence starts and while the other side is still cooperative.
- A view on whether the multiple looks defensible on the information available
- Where we would expect diligence to find problems
- An honest answer if you do not need a full engagement
Avnit will email you back. Reply to that message with the letter of intent attached.
No cost. One business day.
Send us the LOI and we will tell you what we think.
A free review of the letter of intent and the purchase price, back within one business day. If we think you do not need a full quality of earnings, we will tell you that too.