Quality of Earnings Analysis: What You Need to Know Before Buying a Business

My Guest

My guest today is Chris Hutchinson, a Partner in Ernst & Young’s Transaction Advisory Services Group.

Chris has over 15 years of experience advising clients on M&A, financings, valuation projects, and due diligence mandates, with a specific focus on private lower-middle-market businesses. Chris and his team have completed an untold number of Quality of Earnings (“QofE”) mandates spanning countless industries, including software, technology, business services, distribution, and retail, among others.

Chris graduated from Queens University with a Bachelor of Commerce, and is a CPA, CA, and a Chartered Business Valuator.

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Specific Questions and When They’re Asked

Quality of Earnings 101

  • (2:35) What is quality of earnings analysis? By extension, what is it not?
  • (4:50) How frequently are you working on the basis of audited vs unaudited financial statements?
  • (5:45) Is a QofE analysis required for companies that have audited financial statements?
  • (8:20) In what situations will banks lend against a deal that does not feature a QoE?
  • (10:30) How can acquirors best manage costs? Can QofE providers “stage” their efforts to complete some basic diligence while still keeping costs at a manageable level at the early stages of a deal?
  • (14:00) What are the first/most important things that QofE advisors look at within a target company?
  • (17:35) When should buyers loop in a QofE provider? When is too early, and when is too late?
  • (20:20) How long should buyers expect a QofE to take?

Current Market Dynamics

  • (22:30) How has the current frothiness of the market impacted the work you do (or no longer do)?
  • (27:35) What is driving the increasing demand among acquirors for companies within the lower middle market?
  • (31:20) How should buyers should think about a target company’s 2020 financial performance in light of COVID? Should we take “COVID-adjusted earnings” seriously as a metric?

Common QofE Themes and Observations

  • (39:20) In performing QoE analyses on small-to-medium-sized businesses, what are the 3-5 most common adjustments or re-statements you find yourself making over and over again?

The Working Capital Adjustment

  • (43:20) What is a working capital adjustment, and why is it necessary?
  • (46:55) How should buyers think about selecting an appropriate working capital peg? Are there any considerations unique to seasonal businesses, growing or declining businesses, etc.?
  • (50:20) The post-close working capital true-up can sometimes be highly contentious. Are there any recurring themes or considerations that tend to lead to more contentious negotiations?
  • (53:50) What have you learned about how to best deal with the seller’s advisors, who at times may be less experienced or sophisticated?
  • (56:45) The definition of working capital is almost never as simple as current assets minus current liabilities. How should buyers think about what to include vs. what to exclude?

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