We have a PE firm asking for a "quality of earnings" report or analysis. Is their a standard form or template for this?
I have never seen a standard on earnings quality. However, the discussion around earnings quality typically covers some fairly standard issues and is used typically by investors to evaluate a company's financial health and whether its reported earnings are accurately representative of the company's "real" earnings or the ability of readers of its earnings reports to accurately predict future earnings.
The idea is to separate the earnings capabilities of the company itself as an ongoing entity apart from anomalous issues, one-time charges, acquisition/divestiture issues, etc. Based on the result, earnings can be deemed either high or low quality.
I have no doubt you could hire any number of consulting firms to do this work for you, or you could do your own work using some logical combination of approaches. The ratios are right out of b-school :).
As a CFO, when I get this kind of question from my board, I always focus on core earnings, organic growth, and free cash flow. But that's just me.
Much further down the page, John suggested this Quality Of Earnings presentation from Tony Enlow, which is really worth taking a look at:
As noted by Mr. Frey, there is no standard for a quality of earnings report.
I associate this terminology with the lower middle market PE firms. In the middle market and above, PE firms generally engage CPA firms or consultants to perform "financial due diligence." In the lower middle market, the PE firms frequently ask for "Quality of Earnings" reports which are, presumably, more limited in scope and lower in cost. Normally, the PE firm would engage its own advisors to provide them with this report, based on analysis of the company's financial information, policies, etc.
The question suggests, however, that the PE firm is still in the early stages and is looking for more information directly from the company. Their focus is likely to be on EBITDA, normalized to exclude nonrecurring items and costs that will be eliminated or reduced as part of the proposed transaction (excess compensation to owners, etc.).
The best thing you can do is to ask them what they are looking for, then deliver exactly what they need.
Both Bryan and Stephen are correct that each quality of earnings is unique to the company. I worked with EY Transaction Advisory Services, where we prepared QofE schedules during our due diligence projects for private equity firms. Since leaving EY, I joined a PE firm where we requested this analysis when we were buying a company as well as when we were positioning a company to be sold. Recently, I started a consulting firm that provides financial due diligence and other corporate advisory services.
A typical QofE schedule begins with reported EBITDA for the last few years, the recent trailing twelve months, and the two comparative stub periods. It's important to list each adjustment (as described by Bryan & Stephen), footnote accordingly as to why it should be an adjustment to reported EBITDA, then ultimately present the Adjusted EBITDA or Pro forma EBITDA.
Pick a P&L format and periods that you think are relevant and can tie back to your audited (I assume) financials and highlight any unusual items line by line. One off sales, sales of excess or obsolete inventory, unusual charges, atypical promotions etc.... It may be interesting to look at your corporate tax return (assuming you're a C corp) and the reconciliation between tax and book earnings to see if anything jumps out at you as unusual. If you have a spare weekend, get Thronton L. O'glove's book Quality of Earnings. It's an interesting read and my help bring out items you wouldn't have considered. Enjoy.
There are templates for such a summary of earnings that I have used and/or developed over the years. Typically these QofE templates are very similar among Big 4 advisors who prepare them. If the VC/PE firm is looking to acquire a company, the QofE will also (or should also) include a distinct analysis of owner 'add-backs'. While every company has its nuances, the VC/PE acquirer tends to normalize performance metrics used across its portfolios and so some of the standard earnings measurements (and the underlying detail and commentary) are often generically applied in a QofE analysis.
I have examples if required.
Courtesy of Tony Enlow. https://www.proformative.com/og/resource/general-content/quality-earnings-presentation. Enjoy!
I have never used a QofE template. It has always been different things in different situations. The goal of a QofE is for PE firms to catch strange items in your financials before they take a closer look. You may start with EBITDA for the last few years. Also show them cash flows. If they come back with more questions, find out what exactly they would like to see.
The simple way of doing the Q of E is take your standard P&L, down to Reported Ebitda, create a section called management addbacks and add in one off expenses that you would define as non core to running your business. Usually legal or consultancy costs. A PE firm should accept that, as they wouldnt really expect you to have a Q of E unless you had retained advisors to compile it for you. But if you think you have alot of issues, hire some one to work through it for you.
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