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Financial Due Diligence: Quality of Earnings

Reasons to enter acquisition transactions are as numerous as they are varied:  increased cash flow, market share, human capital, location, competition, product advantage, goodwill, etc.  At the heart of all these reasons however, is the opportunity for investors to become better off than they were before. 

One of the key metrics in understanding whether a transaction has been successful or not is in the measure of the earnings before and after the close of a transaction.  Accordingly, understanding the quality of the earnings of a potential target company is key in assessing if the target will generate the desired accretive earnings. 

The earnings of a company are considered to be accretive if they have sustainability and can generate positive recurring cash flows.  For example, earnings that are included in slow-moving inventory or uncollected accounts receivable are of low quality.  Also, earnings that are generated by one-time cost reductions are not considered sustainable, and are therefore also considered low quality. 

EBITDA (earnings before interest, taxes, depreciation and amortization) is a common proxy for controllable cash flows of the company.  However, depending on the nature of the Company’s operations, other metrics like FCF (free cash flows) or EBID (earnings before interest and depreciation) is a better metric.  Overall, the metric used should be an appropriate proxy of recurring, controllable and sustainable cash flows.  Factors to consider when analyzing quality of earnings include the following:

  • Non-recurring transactions are events that either positively or negatively affect earnings but do not represent recurring cash flows.  These need to be normalized from recurring earnings or EBITDA.  Non-recurring transactions may include:  one-time asset or liability write-offs, revaluations, severance charges, legal settlement claims, recruiting charges, management fees, accounting errors, changes in judgemental estimates, owner compensation, non-operating charges, etc.  Note:  some of these costs may occur in the normal course of operations and may not be considered “non-recurring” in nature.  Overall, once normalized, the EBITDA should be a reflection of what an investor can consider recurring cash flows
  • Soft income and revenue recognition are factors that may affect the quality of earnings (EBITDA).  Soft income or income-smoothing techniques – whereby revenue is managed by way of the many different acceptable revenue recognition policies – can impact revenues, and therefore, EBITDA.  Due diligence should analyze any changes in revenue-recognition policies and revenue-valuation policies on a comparable basis both year over year and period over period.
  • Investors should seek to be well- versed in pro-forma adjustments to EBITDA so that they can more easily understand how the cash-flow will impact the company post-transaction.  For example: if a company is operating on a stand-alone basis it can be expected that post-transaction, the operations will be merged with the investor’s current operations. There may also be a number of redundant costs that will no longer occur.  These pro-forma adjustments to reduce the overhead and human capital costs may have a significant impact on the future accretive earnings of the company.  Note:  pro-forma adjustments are important to assess an investor’s view of a target company; however, rarely should an investor pay for pro-forma adjustments.
  • Period adjustments are often required to adjust for management decisions made prior to transaction closing.  If management decided mid-way through the year to hire additional office staff; these costs have not been reflected for an entire year.  EBITDA adjustments should be made to account for a full year’s costs to ensure that all cash flows are accounted for.  Investors should be cautioned that some costs will also generate revenues so that calculating the pro-forma annualized costs may actually result in incremental margins to the company’s operations.
  • Related party transactions can also have significant impacts on EBITDA if a company is part of a larger group that works together to deliver services.  If the transaction is for one of the companies in a group, the stand-alone costs related to the sales and purchases from any other related party company needs to be adjusted to fair value.  Also, related party companies often do not transact at market values.  These transactions need to be adjusted to fair values to ensure that post-transaction cash flows are still accretive to the investor.
  • Concentration risk and seller relationship risk are significant factors when analyzing the quality of earnings.  The seller may have significant relationships with customers and suppliers that may be affected post-transaction when the seller is no longer part of the company.  Accordingly, investors need to assess the predicted impact on the company’s cash flows when the seller’s relationships with key customers and suppliers is terminated.  It is recommended that investors identify these relationships early on in the due diligence process, and with the seller’s permission, work with key suppliers and customers to ensure continuity of current relationships post-transaction.

This list represents a summary of the more common factors that affect the quality of earnings when analyzing a potential target for acquisition.  A successful due diligence process should at a minimum address each of the above issues and many more depending on the investor’s needs.

Rohit Prajapati is a Partner at BGD LLP and is the leader of the Transaction Advisory Services Group. Over the course of his 25 years of experience, Rohit has worked with both public companies and private enterprises, assisting them in realizing consistent successful transactions. More about Rohit.

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