What is Financial Due Diligence and Quality of Earnings?

The term “due diligence” is one that’s tossed around in a number of business sectors, and can even be heard in everyday, casual conversations. When making a big decision, one might ask: “Have you done your due diligence?” In the simplest of definitions, it’s the careful assessment of the pros and cons of a transaction.

When we step into the arena of accounting, financial, and business services, that definition takes on more complexity. 

For companies like EHTC, financial due diligence is an exercise to quantify historical financial performance on a normalized basis. This involves extensive analyses over the financial statements with a focus on key accounts that drive the financial position of the company.

If that sounds like a mouthful, that’s because it is. Let’s break it down into more manageable bites.

First, in any agreement or contract, there are two sides: the buyer and the seller. Due diligence for each party take the following approaches:

Buy-Side Due Diligence involves investigating a target’s business, including its financial results, operations, projections, and other areas of importance as identified by the client. Further exploration into the target’s historical financial results and business, such as identifying matters—positive or negative—that may impact the client’s decision to close the transaction, may also be performed. Buyers typically value potential acquisitions based on a normalized adjusted EBITDA, which is an important analysis in buy-side due diligence.

Sell-Side Due Diligence is the process of preparing a company for sale before a buyer has been identified. Typically, a company will hire an investment bank that specializes in the respective industry. Firms such as EHTC are then hired to perform a quality of earnings (QoE) analysis prior to going to market in order to initially present clean numbers to potential buyers. The procedures are similar to the buy-side process.

It may be a given that the buyer will secure a QoE report, but it’s widely recommended that the seller do so as well. The reasons for a seller to engage in this process are threefold: to present clean adjusted numbers prior to going to market, to improve the chance of the deal closing, and to reduce the risk of litigation. 

Let’s look at those factors in more detail:

Provide adjusted EBITDA prior to going to market. If the seller provides a QoE report that shows the company has clean accounting and no issues, this will reduce uncertainty among potential buyers. Less uncertainty means more bidders, and more bidders means a potential higher purchase price. Sell-side due diligence reports are not intended to only present positive adjustments to EBITDA. A sell-side QoE is meant to provide an objective third party view of the company’s normalized earnings. Presenting both positive and negative adjustments and laying out issues initially to buyers will increase the likelihood of a smooth transaction.

Improving the chance of the deal closing. A sell-side QoE can uncover any accounting “skeletons in the closet” so they can be ironed out before the company starts marketing itself to buyers. The last thing a seller wants is for a deal to fall apart during the due diligence phase because the buyer discovers the EBITDA has been significantly overstated. Going through the sell-side QoE process prior to the buy-side can also speed up closing of the deal. Obtaining a sell-side QoE report can help temper seller’s purchase price expectations prior to going to market and therefore lessening the risk of price retrading and increasing the likelihood of closing.

Reducing the risk of litigation. A sell-side QoE team can help with negotiations and drafting the purchase agreement. The sell-side QoE team can help the seller’s legal team foresee such issues and draft a clear, concise purchase agreement. This is particularly important when drafting the purchase agreement terms for working capital. Presenting a clear view on what will be included and excluded from working capital along with example calculations will go a long way in avoiding any post-close disputes.

Buyers typically hire their own financial advisors even in situations where sell-side quality of earnings are performed, as oftentimes there are multiple interested buyers. Performing a sell-side quality of earnings report will change the process in favor of the seller with any buy-side due diligence now becoming confirmatory versus exploratory. 

Whether you’re looking to acquire a business or sell your business, having a skilled and qualified third party in your corner can make all the difference. To learn more about how EHTC can help, visit our Transaction Advisory Services page. Then, contact us to start a conversation.  

About the Author:

Ryan McCaslin, CPA/CIA joined EHTC in the summer of 2023 to serve as Transaction Advisory Services Partner. He has more than 20 years of professional experience providing accounting, consulting, assurance, and advisory services to middle market clients. In his role at EHTC, Ryan focuses on buy- and sell-side financial due diligence and consulting services. His expertise adds an important facet to the team, allowing EHTC to grow its transaction support offerings.