A Quality of Earnings Report: Where Audits Fear to Tread

You see stellar earnings for a company you’re about to acquire. These figures could be a positive sign—longtime, happy customers behaving as expected, the latest snapshot in an ongoing trend. Or, is this a once-in-a-lifetime fluke, never to be repeated again (and certainly not after you acquire this dud in winner’s clothing)?

The moral of the story: Not all earnings are equal.

As a transaction consultant, I’ve seen my share of M&A deals go sideways. One of the more common and critical mistakes I see is the absence of a Quality of Earnings (QofE) report—the beam of light into the dark corners of a company’s earnings.

No, management’s financial statements aren’t enough—even with an audit

Yet potential acquirers often bypass this important step. “Isn’t an audit of the company’s financial statements enough?” In a word, I tell them: no. In three words, not even close.

Don’t get me wrong. Management’s financial statements serve an important purpose as a due diligence foundation, and audited financial statements give potential investors a level of assurance that the numbers in a company’s financial statements are reliable and accurate.

That said, a financial statement audit tells you what the company’s numbers are. The QofE tells you what the numbers mean, providing a more complete and nuanced view of a company’s health, earning potential, and true cash flows.

A good look behind the curtain

How? The QofE focuses on earnings and working capital. Through a deep dive into a company’s revenues and expenses, a QofE provides insight into the strength of a company and allows potential investors to gauge their ROI.

What’s not in a QofE analysis? Significant non-recurring transactions. Removing these from the QofE eliminates a big source of uncertainty. You’ll know if historical earnings are truly sustainable or if they’ve just been made to look that way.

The information in a QofE is more timely as well. A QofE analysis not only covers the one- to two-year periods of a typical financial statement audit; it will also cover figures for interim periods, for a more up-to-date view of normalized performance. In contrast, audited financial statements typically only present figures from a company’s most recent year-ends.

To put this into perspective: a financial statement would give you performance figures for December 31, 2019—an eternity ago in today’s world. If you’re evaluating a company’s prospects in April 2020, wouldn’t you want something just a little more recent?

Sellers are revealing their skeletons, too

Astute buyers aren’t the only ones requesting a deeper dive into earnings performance. Recently, we’re seeing a spike in popularity of sell-side QofE reports as well.

It’s a smart strategy. By commissioning their own reports, sellers show they are serious about going forward with a transaction at an increased closing speed.

There’s an opportunity to gain leverage as well. A seller can derive significant value in proactively identifying and resolving issues that could become deal-breakers. And if the “skeletons in the closet” are more like undiscovered gems, a seller may boost the company’s value before the sale.

Call Sikich in for a look

You wouldn’t buy a new house until inspectors scrutinize every inch. And you wouldn’t drive a vintage sportscar off the lot without having a mechanic you trust check under the hood.

So why don’t investors always apply this same logic and level of scrutiny to their acquisition considerations?

We wonder this as well. At Sikich, we put the full might of our most senior resources into QofE reporting. Our Transaction Advisory specialists live to put numbers under the microscope and uncover the good, the bad, and especially the ugly.

Prospective buyers and sellers alike leverage our detailed findings and interpretations to gain clarity around business drivers, risks, returns, and profitability. For due diligence you can feel good about, you’re going to want Sikich looking under the hood.