As a business owner selling your business can be an exciting, confusing and stressful situation all at the same time. You may have dedicated a large part of your life to creating and growing an entity and now you will be saying goodbye. Numerous questions regarding due diligence, valuation, consideration structure and many other aspects of the deal will be going through your head. In this post I’d like to take a look at a potential due diligence topic: the quality of earnings report. As the seller you will most certainly be going through a long list of due diligence items for the potential buyer. If you can prepare some of these items in a dedicated virtual data room prior to entering the market you can help save time and get to a close quicker.
A quality of earnings report helps to provide buyers with a deeper insight into the financial workings of a company. The quality of earnings can be classified as either high or low, with companies that do not manipulate earnings being considered high quality and those that do being considered low quality. This is a very important part of the due diligence phase for potential buyers. As valuations are typically based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) it is critical for a buyer to understand historical earnings, trends, key assumptions used in forecasts and the sustainability of earnings.
It is no secret that companies can use one or more of the numerous accounting conventions to help paint a more colorful picture than actually exists. For example, two companies could both experience an increase in net income. One could be due to an increase in sales and the other could be due to a change in how assets and inventory are depreciated. The company that experienced an increase due to sales would be said to have a higher quality of earnings than the company that increased net income by changing depreciation strategies. Any educated buyer will want to know exactly what they are getting into and will spend some time on understanding the quality of earnings of the target.
When preparing to sell their company many owners believe that having audited or reviewed financial statements is sufficient. This is certainly a great first step, but it won’t be the end of the financial diligence phase. Audited or reviewed financials will provide a buyer with a certain level of comfort that the figures have been presented fairly. However, a knowledgeable buyer will still have many remaining questions.
When preparing your quality of earnings report you may want to consider including facts and figures regarding:
1. Your revenue recognition policy (mention if you have changed policies and why)
2. Address any unusual changes in revenue over the last year or two
3. Policies with respect to cost capitalization
4. Address any interest rates on long term debt that are significantly above current market rates
5. Discuss changes in credit policy and why
The above is by no means an exhaustive list. In addition, buyers may also have more qualitative questions about a company’s quality of earnings. These questions may involve the internal controls of the company, the composition of the accounting team and the systems that they use. This information is not something that a buyer can glean by looking at a P&L or Balance Sheet. This information will come out during discussions with management.
A professional quality of earnings report will dig much deeper into the assets, liabilities, revenues and expenses of the company. It is important to remember that buyers are looking for high-quality earning that are repeatable, and not simply due to one-time events.
If you are planning on selling your company it will probably be tough for you to over prepare. Buyers are sure to have numerous questions and it will be tough to prepare for every scenario. Having a quality of earnings report ready can certainly help speed along the diligence process. It is important to include figures that you can justify. A buyer will likely have follow on questions and will want to verify the accuracy of the figures you present. However, having a report prepared in advance is better than having to make one on demand. Being able to demonstrate a high quality of earnings will help make a buyer more comfortable with the transaction and can increase the valuation of your company.