Thorough investigation into the quality of earnings helps buyers
decide if the price of a business is right.
When it comes to buying a business, paying too much for it can have
serious ramifications, affecting financing along with the future
revenue of your business. That's why it's so critical to
understand whether the amount of earnings the vendor is claiming
the business earns is sustainable—and the quality of those
earnings—before you finalize the deal.
Being aware of the quality of earnings isn't just about looking
at the numbers, although that's an important indicator. It
requires developing a thorough understanding of the target's
business.
"We spend several hours talking with management of the target
company before we even look at the detail behind the financial
statements," says John Caggianiello, CA, Senior Vice President
and Director, MNP Corporate Finance in Toronto."That
conversation gets us the information we need to determine the risk
areas for our client: the corporation or the Private Equity firm
planning to buy the business, or the Bank or alternative lender
wanting information for decision-making purposes."
Various areas of the business are explored in the meeting, such as
how the target company acquires customers, how sales are made, what
kind of capitalization policy is used and how inventory is handled.
"You also want to ask questions that can bring things to light
that you'd never otherwise discover, such as what keeps them up
at night or how they would grow the business if money was no
object," says John.
The idea is to learn how the business operates so that financial,
customer and vendor analyses can be done with an understanding of
where the risks lie. "A quality of earnings review doesn't
need to look at every single little thing. That's not cost- or
time-effective," says Vic Kroeger, CA, Senior Vice President
and Director, MNP Corporate Finance in Toronto. "You need to
look at the right things. We tailor the investigation to focus on
specific areas, those of highest risk for the buyer."
While the process always involves pinpointing certain areas, how
you look at those areas will change depending on the type of
business. For example, Accounts Receivable Aging will always be
examined but, says Vic, if you know, through a conversation with
the management of the target company, that one customer makes up 75
per cent of sales, you can focus your work on how quickly that
customer pays, calculate the percentage his purchases have
increased or decreased, determine how vulnerable the company is to
their existing orders, etc. and perform a cursory review on the
rest.
Uncovering The Truth
Every quality of earnings investigation turns up something the
buyer is better off knowing. If it impacts the value of the
business, the buyer and vendor are usually able to renegotiate the
deal in the buyer's favour.
The buyer can benefit even when information is uncovered that would
raise the price of the business. "On one file, we found a
$150,000 error to the seller's advantage," says Vic.
"If the seller knew about it, he could have increased the
price by the five times multiple totalling $750,000." But the
seller didn't get to read the report the buyer had engaged MNP
to complete. "That meant the buyer knew they were getting a
deal and had $750,000 in their pocket to negotiate with," says
Vic.
Even serious issues can be resolved if they are brought to light
before the deal is finalized. In one case, the vendor's General
and Office category in the financial statements jumped from $5,000
one year to $30,000 the next. Delving in, MNP discovered that
overtime was being put into General and Office because the company
was paying cash.
Had the buyer purchased the business unaware of this fact,
potential tax issues, issues with the union, or even a lawsuit in
the future could have been costly. Such serious issues often cause
a deal to fall apart, but in this case, a solution was found.
"The vendor left more money on the table, in the form of a
take-back note, just in case there was future exposure," says
Vic.
In some cases, information about quality of earnings is uncovered
that drastically reduces the value of the company. John offers the
example of a seller claiming $1 million of normalized earnings; the
buyer agreed to pay $5 million based on those earnings. But due
diligence uncovered a significant cut-off problem: the vendor was
pre-reporting revenue, entering sales into the year on which the
price of the business was based instead of in the year when the
revenue was actually earned. Taking out the prerecorded revenue
resulted in a 40 per cent decrease in earnings.
The deal didn't go through, but the buyer avoided a host of
problems. "If we didn't go in, the buyer already had
assumed that the accounting records were being reported properly,
and would have done the deal. And next year, when the financial
statements were done properly, there would have been a big surprise
that would have put him offside on all his financial covenants with
his lenders," says John. "He could have lost the
business."
While it's possible to have your internal accounting team check
the quality of earnings, John warns that there are certain
instances when it's important to have an independent third
party specializing in transaction advisory do the work for you.
This is especially important when you are seeking financing.
Using a third party is also an efficient way to get a labour
intensive process completed without draining your internal
resources. Performing due diligence often takes two to three weeks
to complete and involves working long days. Buyers also need to
consider what they will do if a serious issue is uncovered, as they
will want to access the right advice to renegotiate as quickly as
possible.
Done properly, due diligence to check quality of earnings is like
insurance for buyers. Accurate information in hand, they can
understand the issues ahead of time, renegotiate the deal based on
the earnings that are really there and complete the transaction
successfully.
This article was originally published in PCMA Private Capital Markets Magazine, Spring
2014
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.