Quality of Earnings (Part 2)

We got an idea of what is a Quality of Earnings (“QoE”) analysis, the procedures performed for such analysis, and the purposes & types of adjustments, in our Quality of Earnings Part 1 blog (Quality of Earnings – Part 1). With these basic concepts in hand, we will move toward the second part of understanding QoE in greater detail.

The discussion below gives an insight into some risks and concerns involved in a QoE analysis.

 

Reasons & Methods for Overstating Earnings:

Since management prepares the financial statements, they have the ability to manipulate earnings. The primary reason management would overstate earnings is to obtain a higher purchase price. The following are common ways in which earnings can be overstated, which are important to consider during the diligence process.

Overstatement of Prepaid Expenses

Expenses incurred on a prepaid basis should be charged to the Income Statement during the period in which the benefits of the expenses are recognized. However, when such expenses are not charged during the relevant period and are carried forward on a prepaid basis through the Balance Sheet, the EBITDA is overstated. This can be identified by an unexplained increase in prepaid expenses, over and above the changes to the rest of the working capital.

Capitalized Expenses

Another way management can overstate earnings is by capitalizing expenses as fixed assets. Recording such ‘expenses’ through the Balance Sheet understates the expense charged to Income Statement, thus inflating EBITDA.

One-Time Revenues

Further, there can be instances of overstatement of revenues, due to one-time incomes or non-operating incomes, such as the sale of assets or forgiveness of debts. These should not be included in normalized EBITDA. 

Deferred Revenues

In cases where payments are received in advance from customers, for performance to be completed later, the proper accounting treatment is to record the payment as a deferred liability until the date when the sale is complete. Recognizing revenues upon receipt overstates income. Indicators of a potential overstatement through deferred revenues are a significant drop in deferred revenues immediately preceding the sale, or the existence of long-term service contracts with the absence of a deferred revenue balance all together.  While normalizing EBITDA for deferred revenues is it important to consider expenses incurred in such cases may also need to be adjusted to be recognized with the related revenues.

 

Inherent Risks of a QoE Analysis:

After determining the normalized EBITDA based on detailed financial analysis, there may be certain non-financial risks that might not have been appropriately factored in working out the go-forward EBITDA. There might also be certain assumptions that don’t stand true or new circumstances arising post transaction

A common example can be integration issues faced by companies in terms of standardizing internal processes and controls. There might arise a need for additional training for employees or opportunity cost in case of time lags to solve these integration issues.

Further, standardization of the payroll structure for all employees might lead to employee dissatisfaction and resignations, which were not anticipated while determining the normalized EBITDA.

Additionally, normalized EBITDA essentially consists of multiple assumptions related to growth and trends. Thus, it is also pertinent to take note of the difficulty in precisely projecting future revenue generation, costs of distribution and sales as well as responses of various stakeholders in near future.

Other possible factors that could influence the effectiveness of normalized earnings include the following key main issues, dependence on intellectual property, pricing strategy and elasticity, cost structures, or supply chain disruptions.

 

Other Key Considerations:

In addition to the above, there are certain key points to be kept in mind while computing or using the normalized EBITDA. One such consideration is the differentiation of net income and cash flows. Normalized EBITDA does not reflect the actual cash inflows for the entity. In essence, a net income reflects the book earnings of the company. On the other hand, cash flow reflects the actual cash movements of the business. A comprehensive discussion about EBITDA versus Cash Flows can be referred to in our blog “Cumulative EBITDA to Cumulative Operating Cash Flow Analysis” (Cumulative EBITDA to Cumulative Operating Cash Flow Analysis)

Lastly, it’s also important to understand the inherent bias of each party to the transaction. A sell-side user prefers a higher EBITDA and thus proposes larger add-back adjustments. For such users, normalized EBITDA is a multiple for the value they shall receive in a deal. On the contrary, a buy-side user refers to normalized EBITDA as an indicator of the forward-looking performance of the acquisition and would therefore want EBITDA to be as accurate as possible.

Overall, a QoE report can be instrumental in assessing the go-forward earnings of the business and providing comfort to both the buyer and the seller during the diligence process. Keeping the above considerations in mind, a QoE analysis becomes an integral process in a business transaction and for creating value within regular business operations as well.

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