The Importance of an Earnings Quality Report in M&A Transactions | Timely LLP
Find out why a quality earnings report is essential for the due diligence of M&A transactions or for investing in a company.
A report on the quality of income from a respected industry expert provides an extra level of certainty during a buyer’s due diligence process around an acquisition, or alternatively, gives sellers a third-party view of potential red flags, issues or concerns. areas of concern from outsiders to the industry that they can work to clean up to ensure they enter a commercialization process at the best time to maximize value.
For buyers, a well-done earnings quality report is more than just a stamp to present to investors or internal compliance to sign a deal. An earnings quality report provides valuable insight into historical operations and areas to highlight or areas of concern for future business. For sellers, a well-done revenue quality report allows a third party to peek under the hood of their business as if they were a potential buyer to point out inconsistencies with financials, concern, what to highlight, and what processes to improve to better position the seller to maximize the value of an open market sale.
Once cleaned, an Earnings Quality Report for Sellers provides potential buyers with an added level of comfort during their due diligence process that the financial information they are reviewing has been verified by a third party.
Some of the key procedures in gaining quality are shown below:
- Reconcile historical earnings before interest, tax, depreciation and amortization (EBITDA) with the annual income statement and interim results.
- Understand and evaluate management adjustments to reported EBITDA.
- Review tax return positions and reports.
- Analyze monthly revenue and gross margin.
- Recalculate project-level revenue and savings to verify project savings.
- Analyze the execution rate for the latest 12-month (TTM) and/or year-to-date (YTD) results, adjusted for pro forma impacts; compare to budget and cash forecasts.
- Discuss customer concentrations, credit risk, and any deductions from gross sales.
- Cash flow analysis (i.e. EBITDA vs operating cash flow and intra-month cash balances).
- Summarize historical working capital fluctuations and trends from January 1, 2020 to the date of the last available balance sheet (e.g. 9/30/21).
- Review material contracts for concerns.
- Find out if any off-balance sheet liabilities exist and assess them based on contract review.
A revenue quality report detailing any findings or issues discovered while performing the above procedures is an important part of the M&A Due Diligence process and should not be overlooked.