This Is Why It’s Important to Conduct a Quality of Earnings in M&A

Andrew Jordan is a Principal at Riveron Consulting where he provides transaction advisory services. He’s had his hand in mergers and acquisitions for the last 8 years and has incredible insight regarding quality of earnings (Q of E) and M&A deals.

Quality of Earnings are used to validate earnings. When Company A is trying to buy Company B, Q of E is used to understand the company’s revenue and expense streams. It has become increasingly popular in Europe and the U.S. for sellers, rather than buyers, to seek their own Q of E prior to initiating a deal transaction.

“I think it’s in the seller’s best interest to do a quality of earnings analysis. It prepares them to understand what their true earnings potential is, what their historical run rate has been. It also mitigates another firm coming in and doing a Q of E and finding adjustments that they didn’t know about.”

Andrew believes a seller who comes to the table with a completed Q of E analysis gives themselves several advantages. They may be able to negotiate a higher and better return, while mitigating surprises during the deal process. It also gives the seller credibility and increases efficiency by proactively gathering information needed when the buyer performs their own Q of E. This can lead to a quicker close.

“The whole point of hiring an outside firm to do a quality of earnings is to be objective. When a seller sells, they may try to paint their business as the best business in the world.”

The Q of E brings important objectivity when analyzing data and searching for red flags.

When performing a Q of E analysis, Andrew’s goal is to normalize the data. He removes one-time, nonrecurring and extraordinary items to determine the normal business operation. Andrew has uncovered personal expenses mixed into P&L as administrative expenses, and other extreme, one-off purchases. In response, he adjusts figures, but cautions it’s about more than just numbers.

“If you see unethical behavior, it’s indicative of management and it’s indicative of the owner.”As a buyer, you should give these situations extra consideration. In many cases, the owners and/or management stay involved with the business after the deal closes. You may not want to work with individuals who have demonstrated unethical behavior.

He also believes high quantities of adjustments are concerning. When considering reported inventory, he strongly emphasizes conducting a physical plant tour.

“From a financial standpoint, make sure the proper controls and proper people are in place. You’re doing diligence from an operational standpoint and should look at the actual factory.”

In today’s technology-driven world, it is important to consider computers. Is the company’s equipment and technology adequate and safe? Do they need to upgrade their systems? These considerations may fall outside the realm of typical Q of E, but are important considerations when deciding to move forward with a deal.

Andrew’s biggest piece of advice is to always be objective, always question, and always look for support. “I generally walk into a management interview process and don’t trust anyone.” He purposefully asks the same question three times during a conversation in case the answer changes, or additional details are revealed.

“Make sure you understand exactly how things roll up, how things add together.”

Regardless of your role in the deal, “Try to put yourself in the buyer’s shoes. Then try to put yourself in the seller’s shoes. And then try to put yourself in the advisor’s shoes as well.” In each position, remain objective.

Andrew Jordan has incredible insight regarding M&A. In the podcast, he discusses these topics in further detail: why you should complete a Q of E analysis, ask questions, and be on the lookout for red flags.

Q of E reporting is one of many services provided by Riveron Consulting, a financial advisory firm. With significant experience in industry, management consulting, and the Big Four, Riveron’s consultants assist clients at every stage of the business lifecycle.

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