Quality of Earnings: Important Considerations for Buyers and Sellers
REDW | April 27, 2016
When it comes to evaluating “quality,” buyers, sellers and, most importantly, financial institutions, often have widely diverse opinions, that can greatly affect their decision to proceed with a particular transaction. What’s more, the scope of work, the depth of details analyzed and the length of time they’re reviewed can vary significantly from deal to deal and from industry to industry. One thing, however, remains constant throughout all deals we have had the pleasure to work on: the most important element of quality assessed in any transaction is the ability of the business to reproduce similar or even greater results in the future.
Nobody likes surprises. All parties involved spend considerable time and energy just to get to a proposed transaction. In evaluating the quality of earnings, the elements that always receive significant attention are the depth and breadth of the businesses’ key customer/vendor relationships; repeatable business processes that are executed daily without exception; and the strength of key staff beyond the owner(s). In addition, timely, reliable, and supported financial results, even if showing a loss, generally mean far more than strong results reported months after the fact, if they contain large adjustments and/or questionable reporting practices. Other often-considered elements in quality of earnings are customer concentrations, product diversification, product margins, receivable and inventory aging.
In a recent case we evaluated, the seller presented very good financial results for the most recent 12 months, a strong start to the New Year and a solid quality of the business (pitched by the broker in listing the business). Several buyers expressed interest and one, whom we represented, entered into a letter of intent to purchase. However, as the quality of earnings were analyzed by the buyer and the buyer’s lending institution, it was clear the reported earnings were far from supporting the price offered. The elements of quality that caused the buyer to walk away from the deal were a heavy reliance on the selling owner for all aspects of the business and significant adjustments to reported financial results for “one-time” or “personal” expenses.
Prices paid in many businesses often contain considerable intangible value generated by the businesses’ customer relationships, business practices, and staff talent and knowledge of the business. Quality of earnings goes well beyond looking at the numbers. Involving key advisors early on in the process is critical to assessing the true quality of earnings well before reaching the terms of any agreement or investing significantly in the sale/purchase of any business.