By Randy Misch, CPA | Principal, Audit & Assurance
Net income doesn’t tell the whole story. Even a company with a large net income can be a bad investment due to a negative cash flow or other potential issues. In order to determine if acquisition makes sense for everyone involved, both sides need to review every factor that impacts how a business accumulates cash and how those trends project for the future. Fortunately for business buyers and sellers, that’s where a quality of earnings report can help.
What’s a Quality of Earnings Report?
Quality of earnings is a part of the due diligence process during a merger or an acquisition. During this part of the process, a third-party professional will prepare a report with detailed analysis of the components that make up the company’s revenue and expenses. If you’ve ever purchased a home, you most likely paid for an independent inspector to go through the property prior to the completed sale. The inspector reviews a variety of things to ensure the house is to the standards of the buyer and meets the description from the sellers. The inspection process can also shed light on issues needing to be resolved prior to the purchase, which may not be visible from simply looking at the house. During a business transaction, a quality of earnings report can review parts of the business that may not be seen at surface level – just like an inspector for buying a house.
It’s important to note that a quality of earnings report is not an official audit. It’s also not mandatory for a buyer or a seller to have a quality of earnings report done. However, it’s extremely advantageous for both buyers and sellers to request a quality of earnings report before a transaction, just like the example of a home inspector prior to a real estate sale. These reports are designed to assess a business’ sustainability, determine the quality of its historical earnings, and project the attainability of future cash flow and net income projections. This can help ensure that a business is accurately priced so that neither the buyer nor the seller go through with an improperly-priced acquisition.
When you receive a quality of earnings report, it typically contains several items, such as:
- Breakdown of revenue by appropriate components, such as customers and product/service lines
- Analysis of historic revenue trends
- Determination of one-time expenses vs. recurring expenses
- Determination of fixed vs. variable costs
- Analysis of impact on both revenue and expenses due to management changes
- Analysis of assumptions used in cash flow projections and scenario analysis
Another key part of the process is a summary of Earnings Before Interest, Taxes, Depreciation, and Amortization, also known as EBITDA. This is a method of measuring a company’s operating performance. EBITDA can be much more beneficial than judging a company solely on net income, as it provides investors with an idea of how the company is truly performing and if that trend will continue into the future.
A quality of earnings report will also report on synergies that can improve net income by removing redundancies from future expenditures. For example, let’s say you’re buying a company. If you already have a CFO in place, you won’t need the CFO of the company that’s being acquired. Removing his or her salary will help improve your cashflow and quality of earnings. This goes for outgoing owners of an acquired company as well. If a company makes $1,000 in net income, but the owner makes $1 million, your future net income will skyrocket. Even if you retain the owner in a $200,000 consulting position to help with the transition of the business, the net income of the business will be $801,000 after the acquisition.
Benefits of a Quality of Earnings Report for Buyers and Sellers
A quality of earnings report is beneficial for both buyers and sellers, but the goals are different for each party. For buyers, a quality of earnings report provides a greater understanding of the health of the business and the attainability of future projections. Not only can this help ensure that the buyer pays a fair price for a business, but also can warn them away from a potentially bad investment.
On the sell side, a quality of earnings report can help determine a better selling price of a business. As an objective assessment of the business, the report will give sellers a chance to address any cashflow issues before a prospective buyer goes through the due diligence process. It can also identify non-recurring items that can be added back to EBITDA to get a higher purchase price.
While it’s fairly common for buyers to invest in a quality of earnings report, sellers won’t commit to a report nearly as often, typically because they don’t want to incur an extra cost when they’re selling. This logic can end up costing them, as most businesses are paid on a multiple of EBITDA. If a quality of earnings reports can add $100,000 to the purchase price of a business and you receive five-times EBITDA, that’s an additional profit of $500,000. A quality of earnings report is also like investing in a realtor to sell a house; it can help prepare your business for sale, attract more potential buyers, and sell the business more quickly and at a higher price. Those are benefits that just about any seller can get behind.
When Should You Have It Done?
Another difference for buyers and sellers is exactly when they should invest in a quality of earnings report. For a single acquisition, there’s almost never two separate quality of earnings reports being done at the same time. For the seller, these reports should be done in advance. There isn’t an exact timeline of how long these reports should be done before a sale, but it needs to be done well in advance of selling the business so that you can identify what your desired selling price for the business, discover any potential issues, and clean up any problems.
As a buyer, the timeline is simple: a quality of earnings report should be done as soon as you have a letter of intent. This way you can go through the due diligence process using information gathered by the quality of earnings report to assist in and uncover any issues and truly identify that the business being acquired has earnings that you can rely upon in the future.
Of course, it’s difficult to have a quality of earnings report done if you don’t have a good, independent firm to objectively analyze the business in question. At Apple Growth Partners, our accounting and assurance experts can conduct a quality of earnings report to protect both buyers and sellers. Contact us today to talk to one of our experts about how we can help you and your business during the acquisition process.