Quality of Earnings: Financing Protection

In this episode, we explore the importance of a quality of earnings (Q of E) report during business transactions. In many cases, a Q of E is critical to securing financing and meeting lender requirements. We’ll discuss what a Q of E covers, how it differs from an audit, and when it’s necessary. Tune in for insights on how this process can help avoid surprises and support a smooth transaction.

---

TRANSCRIPT:

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has

partnered with small business owners to prepare for and navigate the business

transaction process. Pull up a chair as we share stories and insights from our

experience on all sides of the M &A

- And welcome back to another episode of Integrated Insights. My name is Michael

Hefner. I'll be your host again today. I'm joined by one of the founders of ICCG,

Grant McQuilken. Grant, thanks for joining me. - Howdy. - Today, we're gonna be

talking about Q of E's or quality of earnings. These are done by banks. We're gonna

talk about what they are and when they happen. So Grant, just to get started,

tell everybody what is a Q of E.

Yeah, you know, that's a great question. It's, you know,

it's, it's generally a deep dive into the financials,

metrics, working capital, accounting methods,

revenue model of a business. And it, It's generally done by a CPA firm that is

typically in the business of doing a test functions and so I think.

You know buyers a lot of times will order a quality of earnings and the reason for

it is it varies so the I I guess what I'm supposed to say is that the reason why

you order it is because it's a really deep dive look under the hood to make sure

that the buyer is not surprised by anything. It's not an audit. An audit is very

different. An audit is an opinion that the financial statements accurately reflect the

financial position of the company. The quality of earnings is more of a deep dive

into what those numbers are, how the revenue model is reflected in the accounting

methods, those kinds of things, metrics, sales by customer metrics,

maybe concentrations, those kinds of things. And I think if I'm wanting to be nice,

they're extremely helpful to a buyer. In the past, in the long time past,

we did a lot of that work as part of due diligence, and so this is not a

replacement for due diligence, but nowadays it's a big part of due diligence for PE

groups, but a lot of times it's just to cover the butt of PE groups who have

limited partners so that they can use a big name accounting firm with a lot of

expertise and a big insurance policy to protect them from making mistakes.

Yeah. And is there a little bit too of like just giving additional insights or is

it Like you said, just there, is it just the mistakes part? - Yeah, I've seen both.

I mean, and I've been impressed with some firms who really,

really help buyers look at what matters in the whole part,

in the accounting or what metrics are important to the buyer.

And then I've seen some that are just mechanical, just clinical, you know,

fill in the spreadsheet and hand it over. And you've got to sit there and interpret

it yourself, basically. And so, I mean, you know, they're helpful.

I think there's somewhat of an insurance policy most of the time, But it's more and

more regular for a P -group, for example,

a buyer to order quality of earnings. It's actually now done by some sellers before

that happens. And so a seller will order one to get ready for the process.

Yeah, I mean, they just want to avoid surprises, want to make sure that they're not

going to get hammered once some big name accounting firm comes in and does it.

We've got a client right now that's doing that. I think it's more typical,

though, if small -medium -sized business doesn't get audits and they're not 100 %

confident that their accounting method is generally accepted accounting principles or

the reflects the timing and extent of revenue and expenses appropriately,

then they want to have a heads up and make sure that they're not getting into

something that they're going to get Drilled come due diligence.

So is there ever a deal that requires to have a Q of E or is it just a matter

of preference and how helpful it will be? Yeah. I mean, look, the only people that

can ever require a Q of E are banks or investors,

right? And so that's why I said P groups, Sometimes it's part of the investment

sort of metric, and then here recently,

when we were representing a buyer,

the bank, his financing source required him to do a QV. And so I think that's

where we've helped buyers

with maybe what is more an affordable option or more affordable option to limit the

scope of a Q of E. If you go into a CPA firm, so I need a quality of earnings,

then they're gonna do their full -blown process. Think car wash,

right? You go in there and you want a detail, right? And that's the only product

that have, then you're going to pay a lot. But if you go in the car wash, and

the only thing you really want is you just drove suit through some mud, and you

want your tires cleaned, right? And so you can limit the car wash to just getting

your tires cleaned, and then you don't pay as much as them thinking, oh,

I've got to detail the inside of the car. And so my point is, is that a limited

-scope QV or quality earnings can really zone in on the metrics that buyers need to

know because those are the metrics that drive the success of the business.

And so an example might be in a medical business, again,

they need to know patient count trends. They need to need to know payers,

who are the insurance companies that generally serve that area and what their rates

are and what is an in -network, out -of -network, all those kinds of things.

They could give a rip what the CPA firm thinks about payroll,

right? So, you talked about CPAs are usually the ones doing quality of earnings. Can

any CPA firm do a quality of earning? Is it the same value one to the next?

I know you talked about scope, but can you go for a similar scope from one CPA

firm to the next and get a similar value out? Or what does that look like? I

mean, quality of earnings is a test function.

And so you have to understand, CPA firms are also, they go through a review every

year. And that review, or not every year for all of them, but that review is light

or intense, depending on the type of work that they do. And so if you're a CPA

firm that does some light accounting and then does tax returns,

you're not going to be able to do a quality of earnings or you're not going to be

able to do an audit, but because those firms, they go through a pretty intense

review to make sure that they're doing those, the process is necessary to make those

opinions worth anything. And so generally, I would say it's your larger CPA firms

that'll do a quality earnings. And honestly, if you're paying that much money to get

a quality of earnings, you want a name behind it that's recognizable or at least

reputable so that you are covering your butt,

like I said, and you're not just having somebody who is going in there and kind of

going through the motions. Yeah, that's great. So in a previous episode, we've talked

about the difference seeing different intermediaries and how we measure up to that.

What you were just talking about about making sure someone's reputable in that

industry and stuff like that, when somebody comes to us and they need a Q of E,

what do we tell them? We just say, "Okay, go do it then." Yeah,

look, I mean, we will only refer them to your firms that are,

you know, that'll lend themselves to, I mean,

that have the reputation, but it's not just about reputation. Again, like I said

earlier, there's some utility to it. You know, they are good at what they do,

and you want them to have that expertise to help you at the same time.

I mean, that's a buyer that comes to us, right? And they want a Q of E. If a

seller comes to us and they say they want a Q of E, we know enough about

accounting to know

let's limit the scope or let's make sure that they absolutely need it.

And it might be better for them to get to hire a,

you know, a sort of a three month stint of a really sharp CPA part -time to go

clean up their financial statements, and that might be worth more than getting a

quality of earnings, right? And so, you know, it's not just, we just don't send

them down the the road to go get one, we really want to know why they're going to

get one and what's the purpose and we don't necessarily automatically tell people

they need to get one. We really wait until we see what the utility of it is.

Yeah. And what I would just add there is we are always meeting with CPAs.

We're always meeting with banks. We are always meeting with business professionals to

make sure that we know how to steer our clients in the right direction and to help

them. So anyone that comes to us is never just out on their own, never just, okay,

go get that done. But we can usually help steer them in the right direction. So

last question I got for you, Grant. How can the results of a Q of E affect a

deal? So you said that there's some KPI analysis in there and some things like

that. How have you seen the results of a Q of E affected deal? Yeah.

I mean, the easiest obvious answer is, you know, that the buyer sees something they

don't like and they retrade, right? They don't want to pay as much.

We see sometimes they notice something and they change their focus of focus of their

due diligence, the add something that's really important to them. If they find out,

for example, one of our clients one year during a Q of E, they didn't like the

fact that we said there wasn't any concentration of sales because a ton of their

customers were actually commonly owned by a parent company, even though they ordered

and dealt with our client separately, they combined them and they wanted to look at

that concentration of sales, for example, and they do diligence. So it didn't change

the,

they didn't come and retrade. They just wanted another look at that. You know,

there's a lot of people who use the quality quality earnings to actually assess what

the right working capital peg is. And so that sometimes changes the deals.

And then just the confidence that lenders and investors have in making the purchase

happen, sometimes it boosts that confidence for sure.

Yeah. So it's a little bit of doubling down on that Dave Parker saying of bad news

doesn't get better with age, right? - Yeah, you bet. - And avoiding that and let

there be no new information and the better, so. - That's right. - Good stuff.

Well, Grant, anything to add before we wrap up this episode? - No. - Appreciate your

time. - Yeah, awesome. Well, thanks for joining me again and everyone will see you

again on the next episode.

And that wraps up another episode of Integrated Insights with ICCG. Be sure to

subscribe and stay tuned for more stories from our team. We love hearing from our

listeners. If you have any questions or topics you'd like us to cover, please send

us an email in the show notes. For more information about ICCG, please check us out

on our website or follow us on LinkedIn and YouTube. Until next time,

there's always a seat at our table.