Recently, some of the comments on one of my posts advised owners to get a Quality of Earnings report before listing their business for sale. It occured to me that many owners are not familiar with the term and how it might factor into a sale. For most sellers of small to mid-size companies, it won’t. Here’s why.
A Quality of Earnings Report is usually performed in deals that involve Private Equity buyers and large deals – those over $10 million. The Q of E report itself is a big investment, usually paid for by the buyer; a report may take months to complete and cost anywhere between $50,000 – $100,000. Private Equity buyers do these forensic reports to assure their investors that they have vetted the company’s financials as thoroughly as possible.
The Q of E report will provide an analysis of the company’s revenue streams, operating expenses, working capital, and cash flow, an evaluation of the accuracy, sustainability, and transparency of financial statements, identify potential risks for the buyer, and look for unusual or unexplained trends.
Smaller sales don’t require this level of investigation, although there will always be a diligence period that looks into a company’s financials. A buyer will look at bank statements, P&L statements, and tax returns to determine “proof of cash,” making sure the numbers add up and make sense.
A quality of earnings report is usually performed by a third-party accountant, although some PE firms have in-house experts. The accountant will look at every bank deposit and withdrawal and try to reconcile them with purchases and other expenditures. They’ll also pore over years of tax returns to make sure all the documentation is accurate. For most business owners, the process is long and challenging; they’ve been too busy running their business to remember what a withdrawal paid for two years ago.
The accountants are also auditing according to GAAP (Generally Accepted Accounting Principles), which ensure that financial records are complete and comparable. Most HVAC business owners work on a cash accounting basis, recording transactions when cash is received or paid, rather than accrual accounting, which records transactions when they are earned or incurred.
A good example of this in the heating and air industry is maintenance agreements. Usually, a company collects payment for them one time a year, say in January, then performs two inspections spaced out over the year. Unless the company is large enough to employ a CFO, most owners just deposit the maintenance agreement payments all at once. A Q of E report will want to break down and document all those kinds of transactions and make sure they’re all accounted for.
In most cases, the Q of E report slows the deal down and doesn’t materially affect the outcome of the sale. That’s why they’re not necessary for smaller deals.
If you wanted to learn more about the benefits of keeping good books or your company, click here.
