Red Flags to Watch for During Quality of Earnings Reviews

A Quality of Earnings (QoE) review is a crucial step in financial due diligence, particularly in mergers and acquisitions (M&A). It provides a detailed assessment of a business’ financial health and sustainability, helping buyers and investors make informed decisions. However, a QoE report can also reveal red flags that signal potential risks. Identifying these warning signs early can prevent overpaying for an asset or investing in a business with underlying financial instability. Below are some key red flags to watch for during a QoE review and their implications for valuation and future performance.

1. Revenue Recognition Issues One of the most common concerns in a QoE review is improper revenue recognition. Revenue should be recorded in line with Australian Accounting Standards (AASB 15), which governs how and when revenue is recognised. Red flags include aggressive revenue recognition policies, premature recording of sales, and inconsistencies between revenue and cash collections.

For instance, a business might record revenue for services not yet delivered or inflate sales through channel stuffing - where excess products are pushed to distributors to artificially boost revenue figures. These issues distort the company's actual performance, leading to an overstatement of earnings and a potentially inflated valuation.

2. One-Time or Non-Recurring Expenses A company’s earnings should reflect its normal, ongoing operations. However, some businesses may include non-recurring income while excluding one-time expenses to make profitability appear stronger. Examples of one-time costs include legal settlements, restructuring costs, or asset write-downs.

While not all one-time expenses are problematic, a pattern of frequent one-offs could indicate that these costs are more recurrent than the business presents. If these expenses are omitted from normalised earnings calculations, it can mislead buyers into believing the company is more profitable than it actually is.

3. Fluctuations in Gross Margins A significant variation in gross margins without a clear explanation is a red flag. Consistent margins indicate a stable business model, whereas unexpected changes may suggest issues such as cost mismanagement, changing sales mix, or inaccurate financial reporting.

For example, if gross margins improve dramatically without a corresponding increase in efficiencies or pricing strategies, it could indicate potential manipulation of costs or misclassification of expenses. Likewise, a declining gross margin trend may suggest increasing production costs, competitive pressures, or deteriorating business fundamentals.

4. Irregularities in Cash Flow Healthy cash flow is a fundamental indicator of a business’ financial health. A strong profit figure on the income statement is meaningless if it is not backed by robust cash flow. Warning signs include a persistent gap between reported earnings and operating cash flow, unusually high receivables, or frequent delays in payments from customers.

For example, if a company’s EBITDA is growing, but operating cash flow is declining, it might indicate aggressive revenue recognition or difficulties in collecting payments. This can have a significant impact on valuation since free cash flow is often a key metric in determining a company’s worth.

5. Unusual Adjustments in EBITDA EBITDA adjustments are a normal part of QoE reviews, as they help normalise earnings and provide a clearer picture of a business’ true profitability. However, excessive or questionable adjustments can be a cause for concern. Common problematic adjustments include unrealistic add-backs for discretionary expenses, overly optimistic projections of future synergies, or exclusion of legitimate operational costs.

For instance, if a company continually adjusts EBITDA upwards due to ‘management bonuses’ or ‘strategic investments’, it may be masking real operating costs. Buyers should carefully scrutinise all adjustments to determine their validity.

6. Dependence on Key Customers or Suppliers A business that relies too heavily on a small number of customers or suppliers is at greater risk. If one of these key relationships deteriorates, the company’s revenue or supply chain could be significantly disrupted. A QoE review should assess customer concentration and supplier reliance to determine how diversified and resilient the business is.

For example, if 60% of a company’s revenue comes from just one or two customers, the loss of a single contract could severely impact future earnings. Similarly, dependence on a single supplier for critical materials may expose the business to supply chain risks, particularly in the face of economic uncertainty or global disruptions.

7. Overstated Inventory Values Inventory is another area where financial statements can be misleading. Businesses might overstate inventory values by failing to write off obsolete or slow-moving stock, thereby inflating assets and earnings.

An effective QoE review will assess inventory turnover rates, obsolescence reserves, and valuation methodologies. If inventory levels appear excessive compared to sales trends, it may indicate problems with demand forecasting or inefficiencies in inventory management.

8. Unusual Debt Levels or Off-Balance Sheet Liabilities A business with excessive debt or undisclosed off-balance sheet liabilities poses a risk to investors. These financial obligations may not be readily apparent from a standard balance sheet review but can significantly impact cash flow and future profitability.

For example, lease commitments, contingent liabilities, or pending legal claims should be carefully reviewed. If a business has taken on significant debt to finance growth, its true financial position may be weaker than its earnings suggest.

9. Weak Internal Controls and Governance Issues A QoE review should also consider the quality of internal controls and governance structures. Poor controls increase the risk of financial misstatements, fraud, and operational inefficiencies. Warning signs include a lack of segregation of duties, frequent accounting restatements, and related-party transactions that lack transparency.

For example, if a business’ financials are heavily dependent on one or two individuals without independent oversight, this could indicate potential governance risks. Investors should assess the credibility of the management team and the robustness of financial controls to ensure accuracy and reliability.

Final Thoughts A thorough QoE review goes beyond surface-level financials to uncover potential risks that may impact valuation and future performance. By identifying red flags such as revenue recognition issues, cash flow irregularities, or questionable EBITDA adjustments, buyers can make more informed investment decisions. Given the nuances of Australian accounting standards and business practices, it is essential to tailor due diligence to local market conditions. Engaging experienced corporate finance professionals ensures that all critical aspects are properly evaluated, mitigating risks and improving transaction outcomes.