Buyers sometimes have a quality of earnings analysis performed as part of the due diligence process when they’re acquiring a company. The quality of earnings report usually focuses on adjustments to the seller’s EBITDA, but it can also analyze the seller’s working capital.

Specifically, a quality of earnings analysis can estimate the amount of working capital the buyer will need to inject when it acquires the firm.

Why does this matter?

Some deals are “cash free/debt free” which means the seller:
(1) Keeps all the unrestricted cash of the selling company
(2) Pays the debt of the selling company

If the seller is going to keep the cash, this means the buyer will need to provide working capital once it takes over the firm.

And the amount of working capital needed affects the purchase price.

Thus, it’s all about valuation.

If the quality of earnings report says the buyer will need to provide twice the amount of working capital it thought it would need, you better believe the buyer is going to try and negotiate the price downward (or back out of the deal).

Thus, a good quality of earnings analysis can not only identify issues with the seller’s earnings, but also catch any potential surprises regarding the working capital that will be needed.

Catching such issues before the deal closes can prevent buyer’s remorse.
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