Quality of Earnings Analysis as an Essential Part of Due Diligence

Financial reports are extremely important data of any business, with the help of which you can tell a lot about the company, up to the projected revenues. However, in doing so, the report must be done truthfully and with high quality. Sometimes, the details of the report may not be entered accurately, and the reason may lie in a variety of motives, for example, the company wanted to “embellish” the company a little before the sale. In order to avoid constantly encountering such a situation, whether you are an investor, seller, or buyer, you need to enter the quality of earnings analysis.

What is the quality of the earnings report?

The quality of the earnings report is one of the most important pieces of data that are verifiable during due diligence. If you are a seller, the report will be called the seller’s earnings quality report, but if you are an investor or buyer, it will be called the “buyer-side earnings quality report”. But there is not much difference, except for the reason for this request.

The profit quality report contains the effect of matters that do not represent actual or standardized performance and cash flows or are not repeatable or sustainable through time. Certain of this could be the outcome of bookkeeping options, while others could be the consequence of the working environment or management decision-making regarding transactions, etc.

Quality of earnings checklist

Below we describe what should go into a quality of earnings checklist:

  • Selling
  1. early revenue recognition
  2. Provision for dubious bills
  3. price variation vs. volume variation
  4. Actual rise vs. rated rise
  • Cost of items traded
  1. Presumption of expense flow for stocks
  2. Liquidation of the LIFO layer.
  3. Losses from stock write-offs
  • Operating costs
  1. Spending on discretionary expenditures
  2. Amortization
  3. Depreciation of Assets
  4. Allowances
  5. Unfinished studies and development
  • Non-operating revenues and costs
  1. Profits (expenses) of disposal of actives
  2. Interest Income
  3. Capital income
  4. Profit taxes
  5. Terminated Business
  6. Emergency line items

Why do I need an income quality report?

Having a quality earnings report can make things a lot easier for an investor or buyer because it contains details that are not easily found in ordinary financial statements. Because of this detail, it helps to determine the exact price of the business.

It should not be confused with the full business valuation process, this document can not fully replace it, but it has a significant value during the structuring of the transaction.

Seller and Buyer Report on the Quality of Profit

A profit quality report offers a number of advantages to both buyer and seller. For example, it can help the seller discover shortcomings that may later become a problem in the deal. So, the seller will be able to prepare the company more thoroughly for the sale.

With this report, the selling company will be able to see the whole process of the transaction through the eyes of the buyer. By correcting all the things that in the seller’s opinion may confuse customers, he speeds up the due diligence process and thus increases the value of the company and its value.  

A potential buyer, or investor, also appreciates the presence of such a document from the seller. After all, relying on financial reports alone would be risky and wrong. The earnings report is an independent document that will show buyers a more realistic picture of the seller’s situation, and decide whether the company is worth the investment and the money it is asking for in its sale.

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