January 24, 2024
Adam Hoeksema
For the last 10 years I have been surrounded by small business acquisitions and have helped hundreds of small business buyers acquire a business through my work as an SBA lender at Bankable and then through our support of small business buyers in the financial projection process here at ProjectionHub.
Over the last year I have really started to dive deeper into the “Silver Tsunami” of baby boomer small business owners looking to retire and one of the areas that really caught my interest was this concept of a Quality of Earnings Report. Although I had spent a decade in the industry, and am an accountant by trade, I didn’t really know much about the process or purpose of a quality of earnings report. Over the last several months I have really studied the quality of earnings process and wanted to put together a guide for the small business buyers that I come into contact with.
My hope is to provide a deep dive into quality of earnings for the average small business buyer instead of a buzzword laden, accountant-speak summary like most of what I have found online.
I plan to cover the following:
With that as a plan, let’s dive in.
What is a Quality of Earnings Report?
In the context of a small business acquisition, a Quality of Earnings Report, also known as a QofE or QoE, is a comprehensive financial analysis of the company’s financial information in order to determine the accuracy, sustainability and reliability of the company’s earnings.
The primary goal of a Q of E is to verify the financial information provided by the seller and to understand the true financial picture of the business you are acquiring. Typically a quality of earnings report is completed by a CPA or other financial due diligence professional.
What is Included in a Quality of Earnings Report?
Although it depends on the type of business, size and complexity of the business you are acquiring, and your budget for a QoE report, the following are common sections to be included on a quality of earnings report.
- Earnings Quality: In this section, you are trying to determine whether the earnings of the business presented on the financial statements are from the core business operations versus one time events, non-recurring activities, or aggressive or sketchy accounting practices.
Example: To bring this to life a bit, in a recent analysis that I was completing as part of our Quality of Earnings Sniff Test service, I analyzed a roofing company that had roughly the following:
2021 Earnings = $1,000,000
2022 Earnings = $1,800,000
2023 Earnings = $1,100,000
It was kind of strange to see such a huge spike in 2022 earnings and then back down to 2021 levels. It turned out that there was a major storm that did severe roof damage in early 2022 for hundreds of thousands of residents in their service area. The storm caused a non recurring increase in earnings, and the buyer of the business needs to know that probably won’t happen again, or at least they can’t count on it.
- Revenue Recognition: In this section you analyze how the company recognizes revenue and whether it complies with accounting standards. This includes looking at the timing of revenue recognition, customer contracts, and any long-term agreements that may impact future earnings.
Example: Let’s say the target business sells a large 2 year contract in December and gets paid up front for the entire $500,000 contract. The company would have the cash in December, but if they count all the revenue in December it would cause the company to look $500,000 more profitable than it should because the contract has not been fulfilled.
If you didn’t dig into this, as a buyer you could think that the company is much more profitable than it actually is and overpay for the business.
- Sustainability of Earnings: This section tries to determine whether the company can continue to earn similar profits in the future, or is there a new technology or shift in the market that could threaten the profitability of the business.
Example: A traditional auto repair shop in California might be facing headwinds over the coming decade as more and more cars transition to electric. Electric vehicles may require less repairs and maintenance, and different types of expertise when compared to a traditional auto shop.
- Working Capital Analysis: This is a really important section of the analysis. The goal is to understand the flows and timing of accounts receivable, accounts payable, and inventory in order to determine how much working capital is needed to operate the business smoothly.
Example: I have seen an ecommerce business that sells 75% of annual revenue in November and December. Because of their size they didn’t have significant leverage over their suppliers, so they had to place their inventory orders in July and pay 50% up front and 50% upon delivery in October. They didn’t get paid for most of their sales until late December. You wouldn’t want to buy this business in June and have little working capital in the bank because you would have no way to cover the cash flow crunch from July to December.
- Expense Analysis: Review of the company's expenses to identify any non-recurring, unusual, or discretionary expenses that may have been included or excluded to portray a more favorable earnings picture. We also typically compare the company’s expenses to industry averages to determine whether any expense categories seem to be out of the ordinary.
- Tax Compliance and Liabilities: Evaluation of the company's tax filings, compliance with tax laws, and potential liabilities that could impact future earnings.
- Debt and Interest Analysis: Analysis of the company's debt structure, interest expenses, and any potential financial obligations that could affect its net income.
Often, in a small business acquisition the existing liabilities of the company are paid off in the acquisition, so the only debt that might need to be analyzed is any loan that is being used for the acquisition of the business. If you are looking to use an SBA loan, you will need to be able to demonstrate that the business has sufficient cash flow to meet debt obligations. This is often measured by your debt service coverage ratio. Most SBA lenders are going to want to see a DSCR of 1.25 or above.
- Adjustments: Identification and amount of adjustments needed to normalize the earnings, providing a more accurate picture of the sustainable earning power of the business.
Typically a small business is not valued based on the net income on the financial statements or tax returns, but based on an adjusted number often called Seller’s Discretionary Earnings (SDE). An example of an adjustment could be that last year the business had a large one time expense to transition to a new software platform. If this expense won’t happen again, the expense can be backed out (adjusted) and thereby increase the seller’s discretionary earnings.
Quality of Earnings vs Audit
A common question is what is the difference between a quality of earnings report and an audit, and if you have an audit done, do you really need a quality of earnings report too? Although both reports can help you evaluate the financial health and accuracy of financial reporting for a business, I tend to think of a Q of E as a report that looks to the future and an audit is designed to assure that there are no material misstatements in historic financial statements.
An audit means something very specifically. They are conducted in a standardized way based on government guidelines.
A quality of earnings report on the other hand can be tailored to the needs of the customer. If you are looking to buy a business and you are comfortable with the revenue side of the business, you might want to focus attention on expenses, proposed add backs and tax compliance only.
Do I Need a Quality of Earnings Report?
No. You don’t have to have a quality of earnings report in order to buy a business.
The argument for getting a QoE completed is basically this: If you are going to spend $1 million to buy a business and potentially take out a loan and personally guarantee that loan and perhaps use your house as collateral etc, don’t you think it would make sense to spend relatively small amount of money to help ensure you don’t make a $1 million mistake.
While I am sympathetic to this argument, I have also helped hundreds of buyers acquire a small business without ever getting a QoE completed. In particular if you are buying a very small business, it probably just doesn’t make sense to spend the money on a QofE.
For example, if you are buying a local salon for $200,000 and you have worked at the salon for 5 years and know the owner, know the customers, and have confidence in your ability to operate the business, you probably don’t want to spend $10,000 to $35,000 on a QoE report. The assurance from the report just isn’t worth 10% of the entire purchase price of the business probably.
It is for this exact reason that we launched our Quality of Earnings “Sniff Test” Report. We figured that for less than $1,000 we could still offer a valuable review that might help keep you from making a terrible mistake and would be better than the common alternative of no QoE at all.
What are Quality of Earnings Adjustments?
During the process of completing a quality of earnings analysis, there may be some adjustments made to the company financials in order to reflect the true earnings of the business. Common adjustments include:
- Non-Recurring Items: Expenses or revenues that are not expected to recur in the future, such as gains or losses from the sale of an asset, litigation costs, or restructuring expenses.
- Non-Operational Items: Items that are not related to the core operations of the business, such as investment income, or gains/losses from foreign exchange.
- Unusual or One-Time Events: Events that are not expected to happen regularly, such as natural disaster-related losses, or significant write-offs.
- Accounting Policies: Adjustments for aggressive or conservative accounting practices that may skew the reported earnings, such as revenue recognition, depreciation methods, or inventory valuation.
What are Quality of Earnings Add Backs?
Add Backs are specific types of adjustments where expenses are added back to the reported earnings to reflect the owner's or management's discretionary spending, non-cash expenses, or one-time costs that are not expected to continue post-acquisition. Common add backs include:
- Owner's Compensation: Adding back excessive salaries or bonuses paid to the company's owners that are above the market rate for similar roles.
- Personal Expenses: Expenses charged to the business that are personal in nature and not related to business operations, such as personal vehicle expenses or travel.
- Non-Cash Expenses: Expenses that do not involve cash outflow, such as depreciation and amortization, can be added back to show the cash-generating ability of the business.
- One-Time or Exceptional Costs: Costs related to extraordinary events, such as moving expenses, legal settlements, or costs associated with a one-time project.
By making these Quality of Earnings Adjustments and Add Backs, a QoE report provides a clearer view of a company's normalized, sustainable earnings, excluding items that are not indicative of the ongoing business performance.
When Should I Complete a Q of E?
Typically a quality of earnings report is completed after you have agreed on a purchase price and terms with the seller. Typically, the buyer will send the seller a letter of intent to purchase the business with specified price and terms. Similar to making an offer on a house, after you make an offer on a house, you typically get a home appraisal and inspection. You can almost think of the Q of E as an inspection for the business.
Although you have already made an offer, if the Q of E report uncovers any major concerns there is still opportunity to renegotiate the price or the terms of the deal. Just like when buying a house, if you found a major foundation issue, you might back out of the deal altogether or at least renegotiate the price.
Again, we felt like there should be some very basic version of a QoE service that could be done BEFORE you make an offer on a business, so your QofE Sniff Test service is geared toward buyers who want to do a quick analysis before taking the time, effort and cost associated with having an attorney draft a letter of intent to purchase the business.
Who Provides a Quality of Earnings Report Service?
Typically an accountant, CPA, or financial due diligence expert will complete a quality of earnings analysis. Many of the large public accounting firms will complete QoE reports, but often they focus on very large M&A activities, not your typical small business.
How Much Does a Quality of Earnings Report Cost?
For a small business acquisition between $100,000 and $10,000,000, most of the Q of E providers that I have found will charge between $10,000 and $35,000 for a full Q of E report.
Of course, if you haven’t made an offer to buy the business yet and you just want a quick analysis, make sure to check out our Quality of Earnings Sniff Test for under $1,000. We would love to help in your business acquisition journey!
