Quality of Earnings Adjustments: Common Adjustments Made During Quality of Earnings Assessments and Their Implications for Lenders

Ever wondered what adjustments are made during quality of earnings assessments and how they affect lenders? Quality of earnings (QoE) reports are essential tools that help lenders, buyers, and sellers understand the true earning power of a business. This comprehensive guide will delve into the common adjustments made during QoE assessments, their implications for lenders, and provide a detailed client story illustrating these principles in action.

Introduction to Quality of Earnings Adjustments

Quality of earnings assessments focus on adjusting a company’s financial statements to reflect its true financial health. This involves making several key adjustments to revenue, expenses, and other financial metrics to provide a clearer picture of the company’s ongoing operational performance. These adjustments are critical for lenders, as they ensure that lending decisions are based on accurate and reliable financial information.

Key Adjustments in Quality of Earnings Assessments

1. Revenue Recognition

Revenue recognition is a fundamental adjustment in QoE assessments. It ensures that revenue is recognized in the correct accounting period, reflecting the actual economic activity of the business.

• Correcting Timing Issues: Revenue recognized prematurely or deferred incorrectly can distort financial performance. Adjustments are made to align revenue with the period in which the related goods or services were delivered.
• Implications for Lenders: Accurate revenue recognition helps lenders understand the true revenue-generating capability of the business, reducing the risk of overestimating the company’s financial health.

2. Non-Recurring Items

Non-recurring items are one-time events that do not reflect the ongoing operations of the business. These include gains or losses from asset sales, lawsuit settlements, and other extraordinary events.

• Exclusion from Earnings: Adjusting for non-recurring items removes these anomalies from the financial statements, presenting a clearer picture of sustainable earnings.
• Implications for Lenders: By excluding these items, lenders can assess the business’s operational earnings more accurately, which is essential for evaluating long-term viability and repayment capacity.

3. Owner’s Compensation

Owner’s compensation often requires adjustment to reflect market rates. Many business owners pay themselves more or less than what an outside manager would earn.

• Normalizing Compensation: Adjusting owner’s compensation to market rates provides a true representation of the business’s profitability.
• Implications for Lenders: This adjustment offers a more accurate view of the business’s operating expenses and profitability, aiding in better-informed lending decisions.

4. Inventory Adjustments

Inventory valuation can significantly impact a company’s balance sheet and income statement. Adjustments are made to account for obsolete, damaged, or overvalued inventory.

• Correcting Inventory Values: Adjusting inventory values ensures that they reflect their true economic value, providing a more accurate financial picture.
• Implications for Lenders: Accurate inventory valuation helps lenders assess the true asset base of the business, which is crucial for collateral evaluation and loan security.

5. Expense Normalization

Expense normalization involves adjusting for atypical or non-recurring expenses, such as unusually high utility bills due to an expansion or one-time marketing campaigns.

• Standardizing Operating Expenses: Normalizing these expenses reveals the business’s true operating costs, making it easier to assess ongoing financial performance.
• Implications for Lenders: Normalized expenses provide a realistic view of the business’s ongoing operating costs, aiding in the evaluation of its true profitability and cash flow stability.

Case Study: A Client’s Journey with Quality of Earnings Adjustments

To illustrate the importance of quality of earnings adjustments, let’s look at the story of John, an entrepreneur looking to buy a manufacturing company. John’s journey highlights how these adjustments can influence a lender’s decision.

Initial Assessment

John identified a promising manufacturing company but needed to secure an SBA loan for the purchase. The company’s financial statements seemed robust, but John wanted a quality of earnings assessment to ensure the numbers were accurate.

• Purpose of the Assessment: John needed to confirm the business’s true earning power and ensure the financials were not inflated by non-recurring items or accounting anomalies.
• Information Gathering: He provided detailed financial records, including income statements, balance sheets, and cash flow statements for the past three years.

Revenue Recognition Adjustment

During the assessment, it was discovered that the company had recognized revenue from a large contract upfront rather than over the contract’s duration.

• Adjustment: Revenue was adjusted to reflect a more accurate recognition over time.
• Outcome: This provided a clearer picture of the company’s true revenue trends, showing more stable and consistent growth.

Non-Recurring Items Adjustment

The assessment also revealed several one-time gains from asset sales and lawsuit settlements that inflated the company’s earnings.

• Adjustment: These non-recurring items were excluded from the earnings calculation.
• Outcome: This adjustment showed a more accurate picture of the company’s operational earnings, which were slightly lower but more realistic.

Owner’s Compensation Adjustment

It was noted that the owner’s compensation was significantly higher than the industry standard.

• Adjustment: Compensation was adjusted to reflect a market rate.
• Outcome: This normalized the company’s expenses, presenting a more accurate measure of profitability.

Inventory Adjustment

The inventory analysis found that some stock was overvalued and included obsolete items.

• Adjustment: Inventory values were adjusted downward to reflect their true economic value.
• Outcome: This gave a more accurate representation of the company’s asset base and financial health.

Expense Normalization

The company had unusually high utility expenses for one year due to a facility expansion.

• Adjustment: Utility expenses were normalized to typical levels.
• Outcome: This provided a realistic view of ongoing operating costs, which were lower than initially reported.

Impact of Quality of Earnings Adjustments

The quality of earnings adjustments provided John and the lenders with a clearer and more accurate picture of the manufacturing company’s financial health:

• True Earnings Power: Adjustments ensured the earnings reflected the company’s sustainable operations without distortions from one-time events or accounting practices.
• Informed Decision: With accurate financial data, John felt confident in his investment decision, and the lenders had the information needed to approve the loan.
• Financial Stability: Lenders were assured of the company’s ability to generate stable earnings and manage cash flow effectively, reducing the perceived risk of lending.

Importance of Quality of Earnings Adjustments for SBA Loans

For SBA loans, quality of earnings assessments are especially important. They provide lenders with the confidence that the business’s financial statements accurately reflect its true financial health. Here are three key reasons why these adjustments are important for SBA loans:

1. Accurate Revenue Recognition

• Consistency: Ensuring revenue is recognized consistently over time helps lenders understand the business’s real revenue-generating capability.
• Reduction of Risk: Accurate revenue recognition reduces the risk of overestimating the company’s financial health, which is crucial for loan approval.

2. Realistic Earnings

• Sustainability: By excluding non-recurring items and normalizing expenses, quality of earnings adjustments provide a clearer picture of the business’s sustainable earnings.
• Long-Term Viability: This helps lenders assess the long-term viability of the business and its ability to repay the loan.

3. Transparent Financial Health

• Clarity: Adjustments to owner’s compensation and inventory values ensure that the financial statements present a transparent view of the business’s financial health.
• Better Decision-Making: This transparency aids lenders in making better-informed lending decisions, increasing the likelihood of loan approval and successful repayment.

Conclusion

Quality of earnings adjustments are vital for presenting an accurate and realistic picture of a business’s financial health. By addressing revenue recognition, non-recurring items, owner’s compensation, inventory valuation, and expense normalization, these adjustments help lenders and buyers make informed decisions.

For further assistance with quality of earnings assessments and business valuation, reach out to Peak Business Valuation at Peak Business Valuation Contact or call 435–359–2684. Accurate assessments are just a call away!