Acquisition Due Diligence With Quality of Earnings Report

When an individual or company is looking to purchase another business, it’s best to do some due diligence in assessing the worthiness of the prospect. That’s where a quality of earnings analysis come into play. It’s a structured and systematic way of finding out how strong and sustainable a company’s earnings are.

Some of the ways a buyer-side report might be used are to:

• Validate the seller’s representations about their business.
• Identify potential deal breaking issues.
• Support decisions on price negotiations.

Quality of earnings reports range from limited to comprehensive. A limited engagement might only check a few key areas of the business or its financial statements, while a comprehensive report analyzes several areas of the company to get a more complete picture.

Some of the things that a quality of earnings analysis might do is assess the quality of revenue sources, identify important trends, review the company’s customer relationships, spot poor accounting practices, assess efficiency in collecting money and paying bills, look at how well expenses are managed, rate liquidity and profitability, analyze cash flow, and highlight potential issues.

Buyers aren’t the only ones that might initiate a quality of earnings engagement, though. Sometimes selling companies have one done to present to potential buyers in order to show the strength of their business or to help identify areas of concern before putting their business on the market. A quality of earnings report might be used to attract investors. And a company might have one done in order to get favorable lending terms from a bank.

There are multiple choices when it comes to quality of earnings due diligence. If you have accounting or finance employees competent in such analysis, you could have them prepare a report, but outside entities are not as likely to trust internal stakeholders as much as an independent third party. There are companies that specialize in only doing quality of earnings reporting. There are mergers & acquisitions (M&A) brokerages that do quality of earnings reports along with valuations. There are CPA firms that do it as an ancillary service. And then there are businesses like AccountAlytix that have a strong focus on financial analysis as well as accounting services.

The price tags attached to quality of earnings analysis can be quite steep. A lot of providers price based on the size of the deal or, in other words, how much the target company is being sold for. Others have pricing tiers based on the revenue level of the target company. Prices starting at $10,000 to $15,000 are not uncommon, with some costing tens of thousands and sometimes even six figures for large companies.

As you can imagine, a lot of quality of earnings engagements tend to be mostly for medium to large companies who can best afford such prices. There are some services that are lower cost and cater to smaller businesses, but even then, you’re often looking at $5,000 to $15,000, which some companies may find prohibitive.

Then there are some software or AI programs that can produce a quality of earnings report, sometimes at a fraction of the cost of hiring real people. The problem is the programs don’t always produce comprehensive or detailed enough reports. Also, someone not versed in such analysis may feed bad info into the program and get inaccurate results. That doesn’t leave many good options for smaller organizations.

That’s where AccountAlytix comes in. We think that financial due diligence should be accessible to businesses of all sizes. We provide quality of earnings reports starting at $2,500. We also don’t base our fees on the deal size or revenue. The price is based on the complexity of the engagement alone.

In addition, we don’t have service tiers. We provide a comprehensive report to all clients.

Our quality of earnings analysis typically involves:

• Researching company history and operations.
• Collecting financial statements from the company, transaction detail reports, tax forms, and third-party statements, including but not necessarily limited to:
  • Income statements.
  • Balance sheets.
  • Cash flow statements.
  • Income tax filings.
  • Payroll tax forms.
  • Bank statements.
  • Loan statements.
• A preliminary review of the financials:
  • Accounting methods used.
  • Accounting software program used.
  • Statement composition.
  • Scanning for errors, omissions, discrepancies, inconsistencies, and inappropriate accounting treatment.
  • Interviewing the staff and management of the target company to ask pertinent questions about the financials.
• Reconciling source documents to the general ledger, such as:
  • Latest bank statement to bank account balance on the books.
  • Loan statements to GL loan accounts.
  • Seeing that payroll filings match the payroll expenses on the books.
  • Making sure that tax filings are consistent with the financial statements.
    • There are often book-tax differences, but the amounts on the income tax forms should be close to the financial statements in most instances.
• Normalizing earnings and adjusting financial statements.
  • Removing one time and non-recurring transactions such as:
    • Gains or losses from selling fixed assets.
    • Write-offs of uncollectible accounts or bad debt.
    • Asset impairments or write-downs.
    • Legal or insurance settlements.
    • Inventory write-downs.
    • Discontinued operations.
    • Other unusual gains or losses.
  • Also removing or adjusting recurring transactions that are ownership discretionary or not a part of core earnings such as:
    • Non-operational income and expenses.
    • Owner specific or personal expenses.
    • Adjustment of excessive compensation for working owners or shareholders, and their family members.
    • Removal of non-working/passive owners and shareholders’ salaries.
    • Discretionary travel and entertainment expenses.
      • Personal travel of owners.
      • Free food and drink for employees.
      • Office lunches or dinners.
      • Office parties.
      • Team events.
      • Employee vacations.
    • Discretionary memberships and subscriptions.
      • Memberships and subscriptions that are not necessary for the company’s core operations.
    • Charitable donations.
    • Depreciation and amortization.
    • Interest expense on debt.
    • Income taxes.
    • Stock based compensation.
• Analyzing the financial statements using financial ratios, trend analysis and visualizations.
• Forecasting earnings for the next year.
• Comparing results to industry averages or benchmarks.
• Assessment of revenue sources.
  • Revenue streams.
  • Seasonality.
  • Monthly profitability rate.
  • Price volatility.
  • Recurring vs one-time sales.
  • Bad debt rate.
• Review of customer base.
  • The number of customers.
  • Duration of customer relationships.
  • Customer retention rate.
  • Customer concentration.
    • Revenue percentage breakdown of customers.
• Assessment of vendor relationships.
  • The number of vendors used.
  • Duration of relationships.
  • Vendor concentration.
    • Cost percentage comparison.
• Review of company management and staff.
  • Operational structure.
  • Management experience and accomplishments.
  • Number of employees and positions.
  • Employee turnover rate.
• Analysis of expenses.
  • Percentage of total for each category.
  • Cost structure – fixed vs variable.
  • Rate of growth.
• Cash flow analysis.
• Liquidity, profitability, efficiency, and debt ratios.
• Listing of revenue producing assets.
  • Inventory and fixed assets
    • Category
    • Age
    • Book value

It’s not unusual for quality of earnings reports to be 70-100+ pages long, like a small book. The reason for this is that some providers like to pad their reports with things that aren’t relevant to most decision makers in order to justify their price tag, like market trends, the competitive environment for that industry, barriers to entry, or the regulatory landscape. Or things that they really have no expertise in such as evaluating legal agreements. You also see a lot of redundancy in their reporting.

Their reports look big and fancy but how useful is it really to the people buying it? Most decision makers don’t have the time to read the whole report when it is as diffuse as that. And they don’t want to waste their limited time on unimportant details.

At AccountAlytix we keep text concise and get right to the point of what’s important to you so that you can read our report quickly. The executive summary section of our reports allows you to get the gist of our findings in just a page or two. We also organize it with intuitive headings and a detailed table of contents to help you find what you need without having to dig.

Last but not least, we can provide a visual dashboard of KPIs, charts and tables.

Have a look at our sample report and see for yourself what we can do for you.