Quality of Earnings Report 101 – What It Is, How It Helps

Quality of Earnings Report 101 – What It Is, How It Helps

Any seasoned professional can tell you that not all forms of revenue are equal. One-time sales differ from monthly recurring revenue, and cash in hand is more valuable than credit on the balance sheet. 

But even those who understand the difference may struggle to look at a company’s books and determine that company’s worth during an acquisition or merger. Beyond gross and net income, there are complexities at work that require a honed financial mind to understand.

Assigning Value to Revenue Streams with Financial Due Diligence

To get a complete picture of revenue health, you might consider an audit. Audits are broad and geared more toward transparency than assigning value to revenue streams. Thankfully, there’s another form of financial due diligence and analysis that can reveal a company’s true potential—a quality of earnings report.

Understanding Quality of Earnings Reports & Their Impact

To fully understand how quality of earnings (QOE) reports impact our decision-making during acquisitions or mergers, we sat down with Steven C. Avis—a Haynie & Company Partner at our corporate headquarters in Salt Lake City, UT. 

After 8 years with Haynie & Company and a quarter of a century in the business, Steven Avis knows a thing or two about revenue streams and their value. Here’s what he had to say.

What is a Quality of Earnings Report?

In our personal and professional lives, most of us are familiar with the purpose of an audit. But a quality of earnings report may mystify us. In simple terms, what is it?

According to Steven Avis, a QOE report is, “An engagement where we come in and look at a company’s financial statements or financial information to provide background on a business that is not obvious to on looking solely at the financial statements—to make sure that they are what they say they are.” 

“Additionally, the QOE report adjusts the historical earnings to take out the non-recurring types of transactions that are not expected to reoccur going forward, providing the buyer with a clearer projection of prospective earnings in the future.”

“They have so much revenue,” says Steven Avis, “but is it good revenue?”

Impressive bottom lines are sure to dazzle prospective buyers, but can that revenue be counted on to reoccur in the future? As far as sellers are concerned, can the value of your revenue justify the price you’re asking? 

For both buyers and sellers, a quality of earnings report provides value by identifying income streams and assigning significance to them. In short, this form of financial due diligence allows buyers and sellers to understand how one company augments or enhances another. 

Why Do You Need a Quality of Earnings Report?

In business, dispassionate, data-driven decision-making is generally preferable. But there’s a component of confidence to every major deal, especially acquisitions and mergers. 

“It provides comfort that what they’re acquiring is correct,” says Steven Avis. “It also almost forces the sellers to make sure everything is correct on their side.” 

“They’re going to get their documentation in place. As we ask questions, they’re going to make sure that everything is in line where it needs to be.”

But that door swings both ways. For sellers, a quality of earnings report can reveal value beyond the bottom line, increasing both your odds of making the sale and the ultimate price. When businesses change hands, confidence is the name of the game. Few forms of financial due diligence clarify the issue quite like a quality of earnings report.

According to Steven Avis, “Any acquisition will be bolstered by a quality of earnings engagement.”

What Makes Revenue More or Less Valuable?

Money is money, right? That may be true in a manner of speaking, but when leveraging your success to acquire another business, the quality of certain revenue streams can have a major impact on the value of the company itself—especially as it pertains to your existing revenue.

That said, what makes some revenue more valuable? 

“If your earnings, for example, are on a cash basis,” says Steven Avis, “or if they are readily converted to cash. So, if you make a sale to a customer over the internet and take the credit card charge, you get the cash right away. That’s a high-value revenue stream.”

Meanwhile, credit revenue is less available and, therefore, less valuable. But even money in hand has limitations, especially if it’s a one-time exchange. 

“If you make a sale to a person on the internet, it’ll likely be a one-time sale. But if you can make a recurring sale, that revenue is much more valuable to the company than just a one-off sale.”

For sellers, identifying valuable forms of revenue can only help. And for buyers, understanding how high-value revenue streams combine with or offset your own sales can make a merger or acquisition that much more worthwhile.

Advice for Sellers During Mergers & Acquisitions

After 25 years of financial due diligence, Steven C. Avis has a few words of advice for sellers. 

“Make sure you go through your books and records beforehand,” he says. 

“Make sure you understand what your transactions are and that if you’ve got anything unusual or a little different, that you’ve got the documentation for it. It will pop out as we go through the analytics. Those anomalies will pop out, and we’ll have questions.”

With a little bit of prep work, sellers can instill even more confidence in potential buyers. “Make sure you have answers to the questions the buyer is going to ask. Otherwise, you may paint an image you’re not really sure what’s going on.”

In other words, a QOE report, “Helps you build a narrative on what’s going on.”

Advice for Buyers During Mergers & Acquisitions

Audits are always a great first step. But for an even more detailed picture of a company’s ultimate potential, Steven Avis highly recommends a quality of earnings report.

“One thing that’s often misunderstood,” he says, “is, technically speaking, a quality of earnings engagement is simply looking at the income statement and what the quality of revenue on that income statement is.”

While audit adjacent, QOE reports grant insights beyond the obvious so that acquiring companies can fully understand how revenue streams relate. 

“When you look at a due diligence report, that’s the biggest part. But when you expand from quality of earnings to due diligence, it includes an analysis of the balance sheet and the equity-type transactions.”

So, while an audit is a necessary step in mergers and acquisitions, it’s not the only step. A quality of earnings report can bring a company into fuller focus while redoubling your confidence in your move.

Trust Haynie & Company for Your Financial Due Diligence

From audits and quality of earnings reports to business consulting and financial forensics, trust the partners and professionals at Haynie & Company. Since 1960, we’ve powered businesses nationwide with the insights they need to make strong decisions. 

For more information on how a quality of earnings report can clarify a merger or acquisition for you, contact Steven C. Avis at our Salt Lake City headquarters. What will quality of revenues mean for your future? Contact us today to find out more.

Understand the Value of Revenue & Make Informed Decisions

Financial due diligence comes in many forms, each offering its own unique take on the value of a business and its earnings. A quality of earnings report is an excellent next step to take during mergers and acquisitions when the future of companies and millions of dollars are on the line. Let a professional CPA from Haynie & Company assist you today by finding a location near you! To learn more about our assurance services, contact Haynie & Company today.