Two terms often used interchangeably by a business buyer are Financial Due Diligence (FDD) and Quality of Earnings (QoE). Although they are related processes used to analyze the financial health of a target acquisition, there are distinctions.
In this article Eric Gall, founder and licensed broker of Edison Business Advisors, 1) Defines what is FDD and QoE, 2) Explains what is common and different between FDD and QoE, and 3) Advises a buyer on when to add a QoE analysis to their FDD.
- What is FDD and QoE?
FDD consists of a much broader analysis of the acquisition’s financial health. It goes beyond analysis of financial information and looks at operational and strategic aspects that may impact future cash flow. This may include evaluating and projecting how operational metrics, market conditions, legal and regulatory compliance, etc. may affect future cash flow.
QoE is a subset of FDD. QoE solely focuses on a much more in-depth analysis of the acquisition’s financial information, i.e., the quality and accuracy of the revenues, earnings, and cash flows. A QoE analysis provides a buyer with greater assurance of the accuracy of the acquisition’s financial information. QoE does not look at operational and strategic aspects that may impact future performance.
- What is Common and Different Between FDD and QoE?
FDD and QoE have many common objectives along with several distinctions:
Risk Mitigation: Both FDD and QoE help identify potential risks and problems that may present themselves when evaluating an acquisition and/or after a transaction. The intent is to mitigate making a poor investment decision. FDD focuses on identifying potential risks and problems through a broader analysis of the acquisition’s financial information, operational metrics, market conditions, legal and regulatory compliance, etc. Whereas QoE solely focuses on the accuracy of the acquisition’s financial information.
Validation of Financial Performance: Both FDD and QoE look to validate the reported revenues, earnings, and cash flows to provide a buyer with confidence in the acquisition’s financial health. FDD focuses on financial information, operational metrics, market conditions, legal and regulatory compliance, etc. to evaluate past performance as well as establish a basis for future projections. Whereas QoE verifies the accuracy and reliability of financial information to ensure there are no material misrepresentations or omissions by a seller.
Negotiation Power: Data derived from a FDD and QoE analysis provides a buyer with a strong negotiating position when the analysis identifies new risks and problems with the acquisition. These risks and problems are often reflected in a revised purchase price and terms. For example, if the FDD identifies significant risks to future performance, e.g., high customer concentration or a pending regulatory action, this may impact a buyer’s price and terms. Similarly, if the QoE identifies an accounting error or misrepresentation, e.g., inclusion of non-operating revenue, such as a PPP loan or insurance payment in the revenues, earnings, and cash flows, this could also impact a buyer’s price and terms. In extreme situations, where errors or misrepresentations break the trust a buyer has in a seller, a buyer may decide to walk away from the acquisition.
Integration Planning: Both FDD and QoE assist a buyer who plans to integrate the acquisition into an existing business entity. Obtaining knowledge of the acquisition’s financial processes helps in planning for a smooth post-acquisition integration process. Subtle differences, such as cash method vs. accrual method accounting or the timing of customer billing, may have a significant impact on important factors, such as cash flow and customer retention. Planning for these differences is often best addressed in advance of the acquisition vs. post-acquisition.
Additional Objectives Provided by FDD:
Understanding Liabilities and Obligations: FDD provides a thorough examination of the acquisition’s liabilities, including debts, contingent liabilities, and contractual obligations. This analysis assists a buyer in understanding the impact these liabilities may have on the financial health and future cash flow of the acquisition.
Evaluation of Working Capital: FDD analyzes the acquisition’s past working capital requirements and assists in projecting future working capital requirements post-acquisition. This analysis evaluates the amount of current assets required to cover current liabilities so the acquisition can meet short-term obligations.
Legal and Regulatory Impacts: FDD analyzes the acquisition’s past legal and regulatory compliance. FDD also looks for pending legal and regulatory actions that may impact future financial health.
3. When Should a QoE Analysis be Added to FDD?
Given a QoE is a much more in-depth analysis of the acquisition’s financial information, it is often an additional expense to a buyer’s FDD. A QoE can often cost from $5,000 for a simple analysis performed by a small CPA firm to hundreds of thousands of dollars on a seven or eight figure acquisition. Before deciding to bear the added expense, a buyer should consider the size and complexity of the acquisition. For small acquisitions, a comprehensive FDD may be sufficient. However, for larger acquisitions or acquisitions where there are legitimate concerns about the accuracy and reliability of the acquisition’s financial information, the added expense for a QoE may be invaluable. A QoE may provide a buyer with the confidence and peace of mind they require to complete the acquisition. A buyer should always consult with a CPA and other financial advisors to help select the appropriate level of analysis for their specific situation.
To learn more about Eric Gall, founder and licensed broker of Edison Business Advisors, click here.
