Quality of Earnings Assessment

In order to gain insight into a company’s future earnings and cash flows, a Quality of Earnings (QE) assessment must be done quickly after the signing of a Letter of Intent. In the M&A context, the QE of a business refers to how close a company’s earnings are to actual free cash flow. A QE assessment will:

  • Analyze the working capital needed to sustain the business
  • Give an understanding of company accounting practices and policies for depreciation methods of assets, inventory, revenue recognition and accruals of expenses
  • Identify the concentrations of risk; reliance on large customers, key employees or sole-source venders
  • Provide insight from the trailing 12-months earnings and cash flows as compared to what has been presented by the target
  • Qualify the market trends in revenues, sales mix and gross margins

High QE for a company refers to the company’s ability to increase earnings by generating additional revenues or by decreasing costs. From the M&A advisor’s prospective, a QE assessment will provide confirmation of the true baseline earnings power of the acquisition target.