Quality of Earnings from Both Sides of an M&A Transaction
Reported EBITDA often plays a central role in determining business value. However, buyers need confidence that those earnings are accurate and sustainable. A Quality of Earnings analysis examines the financial performance underlying reported earnings. It helps distinguish recurring operating results from unusual or nonrecurring activity. The analysis commonly examines revenue recognition, expenses, accounting policies, working capital, and normalized EBITDA. It may also evaluate customer trends and other financial risk. Both buyers and sellers may commission a Quality of Earnings, or QofE, analysis. However, each side approaches the process with different objectives.
Buy-Side Quality of Earnings
After signing a Letter of Intent, buyers typically conduct extensive confirmatory due diligence. A buy-side QofE often becomes a significant component of that review. The buyer’s accounting professionals test the financial information presented during the sale process. They also evaluate whether normalized EBITDA provides a reasonable measure of ongoing earnings. Their analysis may address:
- Revenue recognition and revenue trends
- Gross margins and sales mix
- Customer concentration and retention
- Owner and management compensation
- Nonrecurring income and expenses
- Accounting policies and estimates
- Working capital requirements
- Monthly and trailing twelve month performance
At this phase, unexpected findings may materially affect negotiations. A buyer may challenge EBITDA adjustments, purchase price, or the working capital target.
Sell-Side Quality of Earnings
A sell-side QofE reverses the timing. The seller commissions the analysis before entering the market or before receiving an LOI. Ahead of buyer scrutiny, this process allows the seller to identify financial issues before prospective buyers discover them. The analysis may also validate normalized EBITDA and strengthen support for legitimate adjustments. In addition, management may correct reporting inconsistencies and prepare explanations for unusual results. With greater visibility, the M&A advisor may present the company’s financial performance more confidently and anticipate likely buyer questions.
Quality of Earnings and SBA Financing
Quality of Earnings analysis has also become increasingly relevant in SBA-financed business acquisitions (i.e., deal size <$5M). SBA lenders must carefully evaluate historical financial performance and the borrower’s ability to repay acquisition debt. For change-of-ownership transactions, SBA procedures require lenders to verify seller financial information against tax records. This process places additional scrutiny on the earnings supporting the acquisition.
Within this lending environment, some SBA lenders may require or strongly encourage an independent QofE report for certain acquisitions. The requirement may depend on the transaction size, complexity, lender policy, and the quality of the seller’s financial records. A QofE helps lenders evaluate normalized EBITDA, revenue trends, working capital requirements, and unusual financial adjustments. It may also identify differences between reported earnings, tax returns, and the cash flow available for debt service.
For sellers, this development reinforces the value of early financial preparation. A sell-side QofE may identify potential issues before the buyer submits financial information to its lender. If SBA financing represents a likely source of acquisition capital, sellers should anticipate increased scrutiny of their financial statements. Clean reporting and supportable adjustments may make the financing process more efficient.
Preparing for Financial Due Diligence
A sell-side QofE does not eliminate the buyer’s financial due diligence. Buyers will still perform their own independent analysis. Instead, it prepares the seller for that level of scrutiny. Early preparation may reduce surprises, improve financial credibility, and limit opportunities for unnecessary retrading (i.e., price reductions). Quality of Earnings serves different purposes for buyers and sellers. Buyers use it to validate the earnings they expect to acquire. Sellers use it to understand and support the earnings they intend to sell. When both sides understand the financial story, negotiations can focus on informed transaction economics.
