The Importance of a Sell-Side Quality of Earnings (QoE)

Considering selling your company? A sell-side quality of earnings (QoE) report can be a critical tool to help you maximize the value of your business and ensure a smooth sales process. A QoE not only helps you identify and address any problems before a potential buyer encounters them, but accelerates the sale process by giving buyers a head start on due diligence and building trust.

Typically prepared by an accounting firm hired by the seller, the sell-side QoE is a financial analysis that will help potential buyers understand your company’s financial performance and earnings sustainability. Even though you are the one paying for the report, the goal of the QoE is to provide an objective, comprehensive view of your company’s financial performance, by analyzing the following areas:

1. Revenue. The analysis of revenue will evaluate your company’s sales, pricing strategies, customer mix, and sales channel mix.
2. Expenses. The report also will examine your company’s cost structure, cost of goods sold, operating expenses, and other expenses.
3. Working capital. The QoE takes a close look at your current assets and liabilities, including inventory, accounts receivable, and accounts payable.
4. Non-recurring items. Any one-time or unusual expenses or revenues (i.e., items that are not expected to recur) will also appear in the report.
5. Financial reporting. Finally, the analysis includes an examination of your financial statements, including balance sheet, income statement, and cash flow statement.

Common Issues Identified by a QoE

The QoE report is important because it can point to financial or operational issues—including accounting practices that might be red flags for potential buyers—that could negatively impact the value of your company. By addressing these issues before the sale, you may be able to increase the value of your business, ease buyer concerns, and negotiate a higher sale price. Following are some of the issues QoE reports commonly identify:

1. Problematic revenue recognition policies. Revenue recognition policies can vary from company to company, and some are less clear than others. The QoE will examine your company’s revenue recognition policies for anything potential buyers could see as a red flag.
2. Oddly timed accruals and reserves. Accruals and reserves are accounting adjustments made to reflect future expenses or revenue. These adjustments can be subjective and can even be used to manipulate apparent earnings. A QoE analysis will look for any unusual accruals or reserves and how they have changed over time. If necessary, the QoE will adjust your revenue and expenses to be in accordance with generally accepted accounting principles (GAAP), correcting any mistimed expenses or revenue.
3. Inaccurate inventory valuation. If inventory is a significant asset for your company, the way it is valued can affect your earnings. The QoE will examine your company’s inventory valuation methods for any potential issues, such as obsolete inventory or overvalued inventory.
4. Capitalization of expenses. Some expenses, such as research and development costs, can be capitalized and spread out over several years. This can make earnings appear higher than they should. A QoE will review your capitalization policies for any potential issues.
5. Misidentified non-operating items. Non-operating items, such as gains or losses from asset sales, can have a significant impact on your earnings. The QoE will consider these items and determine whether they are truly non-operating or are related to your core business.

A sell-side QoE will also evaluate your business’s normalized working capital—the amount of working capital required to support your company’s ongoing operations, excluding any non-recurring items. The report will identify any unusual fluctuations in your historical working capital levels and remove any one-time or non-recurring items. The QoE will also look at your working capital policies and compare them to industry benchmarks.

ROI on a QoE

While a sell-side QoE entails a cost—which will depend on the size and complexity of the business—it is typically well worth it. The potential benefits include a higher sale price and a smoother due diligence process.

First, by addressing any issues or discrepancies identified in the QoE report before putting your business on the market, you can potentially increase the value of your business. That means a higher asking price and a higher value at closing.

Second, obtaining a QoE report can save you time during the sale process, because the information the buyer needs is readily available. If, on the other hand, you choose not to obtain a QoE report, potential buyers will conduct their own due diligence to assess the value of your business. Not only can this process be time-consuming, but it may also lead to disagreements over value, potentially resulting in a lower sale price or causing the sale to fall through. In fact, without a QoE report, potential buyers may factor in a substantial discount to account for unknown risks or downsides—or they may be hesitant to make any offer at all.

***

From before you put your business on the market to the moment the sale closes, a sell-side QoE is a powerful tool that can help you maximize value when selling your company. The QoE can help you identify and address areas where your business can improve its financial performance, and it provides potential buyers with the transparency that comes from a detailed, objective analysis of your business’s value. With a sell-side QoE report in hand, you’ll earn the confidence of potential buyers, enjoy a smoother and more efficient sale process, and increase the likelihood of an optimal sale price and a successful transaction overall.