A quality of earnings (QoE) report should accurately represent earnings data that reflects key metrics and business trends. It should expose operational realities and provide insights into changes in revenue stream performance, cost efficiencies, and cash flow dynamics.
Success for private equity (PE) firms and investment banks hinges on accurately evaluating potential investments and optimizing the value of existing portfolio companies. A critical component of this process is the Quality of Earnings (QoE) analysis. Correctly performed, this deep dive into a company's financial statements helps determine the sustainability and accuracy of its earnings.
Traditionally, QoE analyses have been conducted by auditors. However, a QoE analysis from a financial operator’s perspective—through the perspective of an experienced finance and operational professional who has helped run businesses—can reveal nuanced insights about a business's financial health and future potential that accountants with primarily an audit background may miss. Operators with experience in day-to-day financial management and strategic decision-making provide a valuable perspective that aligns short-term performance with long-term growth.
This article examines the critical components of a quality of earnings analysis to understand its nuances. It also includes common pitfalls and best practices for elevating the value of your QoE analysis.
Common Pitfalls in Quality of Earnings
While a standard QoE may identify baseline financial risks, an operator’s perspective uncovers deeper issues that could impact a company’s earnings in the long term. Using detailed data reduces scope limitations.
Typical QoE Provider Approach
- Top-Down Approach: A typical OoE provider will use a top-down approach, utilizing summary financial information provided by the target. This approach results in less accurate adjustments than a bottom-up approach. EBITDA and Working Capital Adjustments are often based on analysis and extrapolation.
- Scope limitations if summary management reporting isn’t available to address an issue or risk. Many typical QoE providers identify Scope limitations that result in material issues that are not quantified. These scope limitations can turn into significant unquantified liabilities or revenue adjustments.
- Analysis of the business is limited by available management reporting. Typical QoE providers base their approach on available management reporting. This results in more time needed by the management team to support the QofE in answering questions and also limits the ways in which the business is analyzed. Revenue and profitability analysis is limited to those views that management reporting is available.
The Operator's Role in Quality of Earnings Assessments
Operators bring a holistic view to QoE analysis that bridges strategy and execution. Where financial auditors primarily focus on financial data and compliance, operators consider a broader context. They evaluate how business operations, market dynamics, and organizational health influence earnings quality. This approach can expose the operational realities underlying financial metrics and provide insights into the viability of revenue streams, cost efficiencies, and cash flow dynamics.
Growth Operators Bring Unique Insights:
- Bottoms-up Approach: We use transaction-level data to produce more accurate Adjusted EBITDA and Net Working Capital amounts. We compile data to allow it to be reused in post-close integration and purchase accounting/ opening balance sheets.
- We work to overcome missing management reporting. If summarized reporting relevant to buyers and sellers isn’t available from management reports, we work very hard to assemble the relevant reporting from transactional level detail. We try to avoid calling out a scope limitation on a material item or risk. Our transactional level detail approach also provides us with answers or more targeted questions, which makes management support of the QofE process more efficient.
- Hands-On Knowledge of Business Operations: Management discussions with the target company and analysis of summary financial data are key steps in our process. As experienced Operators, we narrow our questions and are less burdensome. We are experienced in over 20+ industries and can decipher data to answer our questions about missing data.
- Our Unique Operators lens: We’ve been in strategic operating seats and bring additional value to the QoE report. We go deeper and improve accuracy to create a more strategic tool for the readers of a QoE. We build missing information and an accurate assessment of the valuation information that buyers and sellers need.
Key Components of a Growth Operators Quality of Earnings Analysis
In addition to financial data, a robust QoE analysis encompasses additional operational metrics. Here are four key components that operators consider:
1. Revenue Quality and Sustainability
Revenue Trends and Consistency: Operators analyze trends over multiple periods to detect seasonality, growth patterns, and volatility. Our bottom-up approach results in more accurate revenue recognition and EBITDA adjustments. With transactional level detail, we turn data into insights.
- Customer Concentration Risks: Heavy reliance on a few customers poses a significant risk if one customer leaves. Operators assess customer concentration ratios to evaluate the risk and sustainability of revenue.
- Recurring vs. One-time Revenue: Recurring revenue from subscriptions or repeat sales is generally more sustainable than one-time revenue. Operators examine revenue streams to ensure stable, predictable revenue generation that minimizes reliance on volatile income sources.
2. Cost Structure and Profit Margins
- Efficiency in Cost Management: A comprehensive review of cost structures helps identify whether costs are optimized and scalable. Operators look for excess spending or inefficient processes that may drain profitability.
- Gross and Operating Margins: Operators review the consistency of gross and operating margins over time. Declining margins may signal increased costs or reduced pricing power, impacting earnings quality.
- Variable vs. Fixed Costs: Understanding the breakdown between fixed and variable costs allows operators to see how responsive the cost structure is to changes in volume. In turn, they can identify potential economies of scale.
3. Working Capital and Cash Flow Management
- Cash Flow Consistency: A sustainable cash flow indicates positive financial health. Operators assess whether a company efficiently converts revenue to cash and factors that might impede cash flow, such as delayed receivables.
- Working Capital Dynamics: Operators analyze how effectively a company manages its inventory, receivables, and payables–each of which directly impacts operating cash flow. Effective working capital management can be crucial to success in industries with high inventory or receivables.
4. Identifying and Adjusting for One-Time or Non-Recurring Items
- Normalization of Non-Recurring Expenses or Revenues: Operators adjust for one-time items, such as legal settlements or extraordinary gains, to ensure the earnings quality accurately reflects ongoing business operations.
- Impact of M&A Activity or Restructuring: Operators examine the effect of mergers, acquisitions, or restructuring initiatives on earnings. These events often bring temporary costs or revenues, so adjusting for these items is crucial for an accurate QoE assessment.
Best Practices for Operators in Conducting Quality of Earnings Analysis
An operator-led QoE analysis is thorough, data-driven, and aligned with immediate financial performance and long-term strategic goals. Here are best practices for private equity (PE) firms and Investment Banks looking to optimize their QoE assessments:
- Collaborate with Finance and Operating Teams: Combining insights creates a more comprehensive understanding of earnings quality. Operators encourage cross-functional collaboration for a holistic analysis.
- Leverage Technology and Data Analytics: Advanced data analytics tools can help operators quickly identify trends, flag anomalies, and highlight areas for further investigation.
Strategic Services for Clear Decisions
At Growth Operators, we believe a QoE report overseen by a seasoned finance operator offers the most detailed insight available to buy-side and sell-side stakeholders. Utilizing a unique bottom-up approach, our team uses transaction-level data to provide:
- Accurate adjusted EBITDA and Net Working Capital metrics
- Analysis of summary financial data
- A broader set of analyses for revenue and margins beyond existing management reporting
- Compiled data for post-close integration and opening balance sheets
- Identification of opportunities for synergy in post-close integration
- Suggestions for operational improvement
Don’t Overlook The Value of an Operator-Led QoE Analysis
An experienced operator can help PE firms and Investment Banks uncover deeper, more actionable insights into earnings sustainability by focusing on the operational realities that drive financial performance. For firms and M&A advisors looking to buy or sell, an enhanced QoE approach followed up with the added benefits of our nextLEVEL® Assessment and post-close services may improve strategies and decisions.
No matter which side of the deal you’re on, our team’s operator-led, hands-on approach ensures we’re actively involved at every stage. Our adaptability extends beyond service delivery to our fee structure, offering the flexibility you need to optimize outcomes.
Great Companies are More Valuable Than Good Companies.
Connect with the experts at Growth Operators to learn how our operator's lens quality of earnings analysis and nextLEVEL® assessment can help maximize your investment value and ensure sustainable growth.