Importance of Quality of Earnings

Quality of earnings is a crucial part of any company sale. It allows you to get a picture of the company's real value being sold and an overview of what it would look like on another ownership. Preparing a QofE analysis will help you negotiate better whether you are a buyer or a seller. Discussing the importance of a QofE is Andy Jordan, Director at Cohen & Company. 

"When I get financial information, it's just numbers on a page. How do I know that these numbers on the page are truly valid? I need to look at things. I need to test them. I need to touch them." - Andy Jordan.

Before we can understand the importance of a QofE analysis, we must identify what it is first. According to Andy, a QofE is a validation of a particular company's earnings stream for the last 2 to 3 years by removing anomalies and one-time events that may affect the bottom line numbers. In simpler terms, the purpose is to evaluate the company's normal run rate on a go-forward basis without calamity or owner-specific costs.  

These one-time costs are usually personal expenses of owners if it's a mom-and-pop shop. It could also be a lawsuit-related cost or huge severance pay for an employee who just left the business. Very rarely, but possible, it could also be unethical behaviors such as bribes and illegal compensations to certain people. These are non-recurring, extraordinary items that need to be adjusted to get to the quality of earnings. 

According to Andy, one of the things you should look out for is the quantity of adjustments. If there are too many adjustments to be made, it could indicate that there's something wrong with the company. 

However, you should also consider categorizing the adjustments based on their nature. For example, maybe 20 adjustments are under the category of personal expense and should be treated as such. This is pretty common when you are working with private sellers.

"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."

Why is it important for the seller?

Andrew believes that it's in the seller's best interest to do a QofE analysis, not just the buyer. It helps them prepare and understand the true potential earnings and the historical run rate of their company. It also mitigates the potential buyer's risk coming in and finding adjustments that the seller didn't know about. This will cause them to lose negotiating power. The more surprises the buyer will see, the lower the price will be. 

Numbers can tell a story, and it is all about interpretation. The more you know about your business, the more you can explain why the numbers are like that, giving you more credibility. 

It can also help you close the deal faster. Assuming that the buyer trusts your QofE analysis, then they won't do it anymore. If ever they would still like to do their own, the data are already prepared because you've already gathered some adjustments.

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