Understanding Quality of Earnings Analysis: What It Is and Why It Matters in M&A Deals

 

This article originally appeared on kappacourse.net

In M&A deals, quality of earnings is considered important because it creates a window through which the potential buyers can appraise the value of the target firm. It goes further than just looking at the naked earnings and identifying how sustainable and reliable it looks. No. There are two aspects that often define an investment decision.

The first is accuracy of valuation. The value of a company in an acquisition and merger scenario depends on the future cash flow, which is derived from the earnings. Accurate earnings indicate that the reported profits are likely to be real and recurring and hence make for a more sound model for financial valuation. On the other hand, if the quality of earnings analysis shows that most of the earnings are from non recurring events, non operational activities or if there is high use of aggressive accounting practices, then the valuation could be lowered.

Second is investor confidence. The quality of earnings has a significant impact on the confidence level of prospective investors or acquirers. Accurate profit statements help in making a company a more attractive proposition for acquisition, because they lower the perceived risk of the investment.

 

Identifying Potential Risks

A quality of earnings report enables the acquirer to identify potential risks in the target firm, which is crucial when deciding whether to proceed with the transaction and the terms of the transaction or not. Things that a quality of earnings report could help identify include:

a. Revealing Hidden Liabilities

It is often the case that while a company’s financial reports look healthy, when subjected to quality of earnings analysis, it is realized that there are a lot of problems in areas like underfunded pension plans, expensive pending litigations, among others—which negatively impact the health of the company.

b. Sustainability of Operations

Looking at the magnitude of earnings that emanate from core and non-core operations, the analysis can reveal whether a company’s operations are sustainable or if there are operational problems that may affect future earnings.

c. Integration Challenges

Quality of earnings reports also assist in determining the extent to which the operations of a target firm can be synergized with those of the acquirer. If earnings quality is low or depends on non-recurring or sporadic revenues, it may indicate integration issues that not only may have an impact on the combined entity’s future revenues, but also the costs and processes associated with post-acquisition integration.

 

The Process Involved in Quality of Earnings Analysis

 

 

a. Preparation and Planning

Gather Financial Statements: Request the income statements, balance sheets, and cash flow statements of the past few years.

Identify Key Areas of Focus: As a result of the initial assessment, determine which aspects may need greater scrutiny.

 

b. Detailed Analysis

Revenue Analysis: Analyze the revenues to differentiate between the current and deferred revenues. Review industry standards for reporting compliance and accuracy.

Expense Review: Check for any irregularities or variations in the expenses. Look for one-off costs, low or high costs, and the rationale behind the costs.

 

iii. Cash Flow Examination: This is done by comparing the cash flow statements with the income statement and looking for differences that may suggest that the company was engaged in some “creative accounting” or that it was using some aggressive accounting techniques.

 

c. Adjustments

Some adjustments may be made to the earnings to eliminate non operating income or gains and losses. This normalization gives a better picture of sustainable earnings.

 

d. Quality Assessment

Discover any factors that may have an unfavorable effect on the future profits, including customer concentration, potential litigation, etc.

 

e. Reporting

Prepare a Detailed Report: Prepare a detailed report of the findings that includes the quality of earnings, any issues of concern, and implications for valuation.

Recommendations for Further Investigation: If required, suggest some more investigative areas or due diligence activities based on preliminary findings.

 

Scenarios That May Influence an M&A Decision

 

Example One: Overstated Earnings

An M&A case study involved an acquirer who wanted to acquire a mid-sized manufacturing firm. When conducting the quality of earnings analysis, it was realized that the firm had a tendency of inflating its earnings by capitalizing typical maintenance costs, which were supposed to be reported as expenses. This over-emphasis exaggerated the company’s profitability. Consequently, the acquirer adjusted the price down by 20%—to an amount that was in line with the economic reality of the target company—to avert overpayment due to inflated figures.

 

Example Two: Withdrawal from a Deal Due to Revenue Recognition Issues

In another case, an acquirer was assessing a software company and as a result of getting a quality of earning report done, he realized that a large part of the company’s revenue was coming from the recognition of long-term contracts. This approach was not in line with the industry’s standards and posed a high risk. Because of these results, the acquirer decided to pull out of the deal, considering it too costly, as he was unsure of the company’s actual financial status.

 

Financial due diligence, especially a quality of earnings report, plays a critical role in M&A transactions. It is a valuable method to assess the actual financial capability of a target company, which exists beyond the balance sheet and income statement. It assists in assessing risks and losses that may be likely to impact the worth and future earnings of an enterprise in the long run.

Organizations with the right attitude towards QofE will be in a better position to perform due diligence to make the right decisions, bargain for a better deal and acquire targets that are healthy, viable and strategic to their business.

In conclusion, the quality of earnings is indispensable information for all stakeholders engaged in M&A activities; it helps them to avoid the pitfalls in this process and obtain results that reflect the actual economic reality of the companies. Closely monitoring financial management guarantees that investments are done in the right manner, safeguarding interests as well as helping investors achieve healthy mergers and acquisitions.