By Mike McSweeney |
March 12, 2015
The Essential Guide to: Quality of Operations
As we all know, there is a direct link between the way a business operates and its financial performance. EBITDA, cash, and revenue can all be attributed to underlying process flows (i.e., operations), despite being financial, not operational metrics. Good sales processes drive revenue, sound inventory or cost management processes control cash, and EBITDA is a function of selling a product or service more efficiently than it costs to make or deliver the product.
Despite this, middle-market investors have historically relied on traditional accounting diligence to understand earnings and financial performance – the Quality of Earnings (QOE) report. Beginning in the early 2000s, however, the investment industry started to experience a paradigm shift – more attention was being paid to operations and value enhancement, as financial engineering on its own was not providing required returns to investors.
Conducting a Quality of Operations™ Analysis, a.k.a. Operational Due Diligence is becoming mainstream, and the industry now values the “QOO” as much if not more than its financial counterpart, given the QOO’s ability to create rather than measure shareholder value.
Before we get into the details of QOO, it’s important to familiarize ourselves with the purpose and history of the QOE to demonstrate the relationship between them. First – there is no single definition of QOE, and there is no agreed-upon industry standard. Its roots trace back to the 1970s and ‘80s, when it was developed by professional investors who needed a way to ascertain company valuations based on true earnings, not accounting anomalies. At that time, the industry lacked a universal, objective form of measurement.
Today, the general consensus is that the goal of the QOE is to allow the user to judge current income and prospects for the future. Taken as a whole, the Quality of Earnings can generally be summarized as the degree to which earnings are:
- cash or non-cash
- recurring or non-recurring
- based on precise measurement or estimates that are subject to change.
Essentially, the QOE helps to quantify and qualify historical earnings, while providing some insight into actual earnings and potentially where value-destroying activities are occurring. However, it does not show the true capabilities of the organization or how to take challenges and turn them into a springboard for improvement.
Understanding the Quality of Operations Approach
Like QOE, the terms “Quality of Operations™” and “Operational Due Diligence” have no single, agreed-upon meaning. That being said, the longevity and near universal use of QOE in the marketplace has created some accepted criteria. This is not yet the case with operational due diligence, but standards are developing as the process evolves.
The goal of the QOO is to allow the user to judge the current state of operational performance and understand the sustainability, predictability and certainty of future performance, including its impact on/correlation to financial statements. The quality of operations can generally be summarized as the degree to which operations are:
- Optimized for Operational Excellence
- Sustainable at current / planned capacity and margins
- Performing at/near/above benchmarks within an industry (Inventory, cycle time, etc.)
- Efficiently deploying capital (working capital, human capital and intellectual capital)
- Supported by reliable fixed assets or at risk of unplanned capital expenditures
- Producing/delivering high quality products that meet known customer expectations
- Led by a competent leadership team focused on continuous improvement.
Over time, we have found that the more detailed and disciplined the approach up front, the more successful the investor, as they work to execute against an investment thesis that is grounded in a realistic view of the organization’s capabilities and its prospects for operational improvement.
QOE and QOO: A Powerful Pair
The Quality of Operations™ dovetails with the QOE nicely. While the QOE provides perspective on the historical financials, the QOO provides a bird’s eye perspective on what drove historical numbers and what can be done in the future to drive positive change (i.e., increased cash flow and EBITDA). When paired with the QOE Analysis, an investor is provided with a holistic view of financial metrics, and what shareholders can do through operational enhancement initiatives (e.g., Lean, Supply Chain etc.) to improve those metrics.