By Brandon Fredericks, CPA | AGP Advisory, Leader
In this part, I want our discussion to get right to the heart of the main cornerstone of any transaction—the earning capabilities of an organization. Regardless if you are looking to acquire a business or ready to sell, all conversations will lead back to earnings. Therefore, the ability to approach a financial due diligence project with a clearly defined concept of earnings, will significantly enhance the transaction’s position.
Before we jump into defining earnings, let’s define what gives earnings “quality.” Our approach is simple – for earnings to be of high quality it must (a) reflect true cash flow and (b) be sustainable. Let’s break that down.
For example, a business with a very high accounts receivable, has essentially recognized a healthy amount of sales. Though good in premise, for a potential buyer, these receivables have yet to be realized. Thus, until cash is collected, these receivables present an issue to a buyer since cash is not yet received.
Let’s look at another example. A business with high receivable, if they are producing a special one-time product, that would not continue, that should not be defined as a high-quality earning and should be adjusted (discussed in future segments). This would demonstrate a situation around unsustainable revenue streams. In both cases, these would present situations were a potential adjustment could be made.
The most common metric used within the industry is earnings before interest, taxes, depreciation, and amortization (EBITDA). This is a great metric to use and one that is easily understood. However, we must recognize each transaction brings its own set of challenges. For example, if the business at hand is an online retailer and is set up as a S-Corp, it is reasonable to assume net working capital needs and long-term investments will be low. Further, the entity itself is not burdened by complex tax situations. Using EBITDA would provide you a financial metric, but the question you must answer is does it really help you answer the fundamental question of “What is the cash I can expect the Company to earn?”
For that, you may want to consider a free cash flow model. There are various ways to calculate this and you want to make sure your approach reflects the transaction and business, but a common way to calculate is simply taking the cash flow from operating activities and subtracting any capital expenditures incurred. A free cash flow metric allows us to see the cash that could be available to a buyer for this company, and also helps bring to the surface potential fundamental problems within the business that have yet to arise on the income statement.
The takeaway from our segment today is defining what “quality” earnings means to a specific transaction. Once you have that North star, you can begin to align all other due diligence procedures.