Quality of Earnings Missed the Mark: Avoiding Future Shortcomings

October 11, 2019  |  By Phoenix Management  |  3 Minute Read

In our “First Call” blog series, we are providing insight on common business challenges. In this entry, we discuss methods to unearth potential problems and pitfalls while conducting due diligence.

Before closing an exciting, new acquisition, you have taken all of the necessary steps towards success: exhaustive accounting diligence, a quality of earnings (QofE) analysis, and a balance sheet investigation. Everything points to strong synergies and a positive result from the transaction. However, as you live out the acquisition, the forecasted positive outcomes never come to light, and it becomes more and more clear that your enterprise’s Quality of Earnings missed the mark. So when the next opportunity rolls around, and your Quality of Earnings once again supports the acquisition, you take a moment to pause. Did your QofE unearth all of the potential problems and pitfalls this time, or are there unanticipated obstacles that you will face down the road?

It can be quite daunting when reality does not line up with your promising Quality of Earnings, and tempting to assume that lackluster performance is due to an error in the report. However, unexpected challenges often come down to the data not included in the report.

To best uncover this vital information before signing the dotted line, there are a number of possible courses of action you can take:

1. Assess Enterprise Value Internally

First up comes the clearest option: leverage internal assets to conduct a Quality of Earnings report during due diligence. As seasoned experts, you are confident your investment committee is able to assess enterprise value accurately. Yet, your committee has a vested stake in the prospect, that, despite their best efforts, can cloud perception of the viability of an investment. Further still, it is possible that a numeric report alone cannot unveil all of the potential pitfalls. Rather, a myriad of qualitative factors that do not appear in a QofE could lead to poor performance following the acquisition. As such, while an internal assessment is a vital step of the process, it is not the only precaution you should take.

2. Rely on Third-Party Insight

Alternatively, you could turn to outside insight and consult an accountant or specialized financial due diligence agency that can assist in compiling a quantitative assessment of the prospect. This provides a great wealth of insight into the numeric considerations of an investment, and eliminates the inherent risk of bias that an analysis by an internal team alone can cause. Yet, it once again approaches the situation from a numbers-only perspective, failing to acknowledge some of the key qualitative factors that are equally critical to outcomes. In order to see the full picture, you require an analysis that captures both quantitative and qualitative data, viewing one in the context of the other for a more comprehensive understanding of the opportunities and obstacles.

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3. Perform a Quality of Enterprise® Assessment

The sweet spot for evaluating an investment therefore lies in the ability to accurately capture the numeric data and understand it in the unique context of the organization. A Quality of Earnings report gets you part of the way there, but misses the expert eye needed to look beyond the analysis and at factors such as resources, company culture, and leadership, which can help evaluate hiccups along the way. Geared towards identifying risks and confirming synergies, a Quality of Enterprise® assessment fills this gap by adding an additional layer of analysis to standard financial reports. Experts who specialize in Quality of Enterprise® reporting analyze both qualitative and quantitative factors, leveraging a much more reliable and holistic prediction of earnings to make a recommendation. With a more comprehensive view of the situation, the expert can uncover gaps or hidden risks in the investment that would otherwise have gone unnoticed until after capital was invested. This leads to a more complete understanding of the potential synergies and establishes a more accurate integration plans prior to investment.

Quality of Enterprise® Reports from Phoenix

Phoenix’s Quality of Enterprise® assessment combines a Quality of Earning and Quality of Operations assessment to create a unique vantage point into the pipeline of middle market flow. By drawing on a history of hundreds of unique engagements, our professionals blend an array of business insight and financial acumen to evaluate the viability and threats of a potential investment. Our team recognizes that success hinges on far more than what the numbers show, and as such takes seasonality, operations, synergies, facilities, management, culture, vision, and more into consideration, in order to minimize risk and maximize ROI. Contact Phoenix to learn about the vast experience and industry knowledge our professionals can bring to your next assessment.

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