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Quality of Earnings Points to Enduring Earning Power

Business owners preparing to sell their company can boost confidence in their numbers with a high quality of earnings report to validate that its profits are sustainable over time.

A quality of earnings review is like a financial statement audit but goes well beyond the balance sheet. By focusing on the company’s earning power, this type of due diligence can enhance the company’s value and mitigate surprises that could emerge later in the sales process.

Not all earnings are created equal. A quality of earnings review weeds out anomalies that may skew the seller’s true financial picture. It can identify non-recurring revenues or expenses, accounting practices that hide poor sales and other unreliable performance indicators. Without this review, the company’s value could appear greatly inflated.quality of earnings

For example, a company that increases profits each year by becoming more cost efficient or executing successful marketing campaigns would be achieving high quality earnings. A company that earns more profits due to rising commodity prices or savings from unfilled executive positions would not.

Sellers should think about quality of earnings before it’s time to sell so they can position themselves as strongly as possible.

The buyer, who conducts and pays for the quality of earnings review, wants to know whether the target company’s acquisition may be riskier than its financial statements indicate. The analysis will look for overstated or understated assets and liabilities and break down cash sources for events, such as transfers to pay off debt or make investments. Typically, it examines the past three years of financial statements and includes an analysis of sales.

Income statements by themselves may not contain relevant details on sustainable earnings. In many cases, lower quality earnings are by their very nature more subjective or have a higher degree of uncertainty.

Sellers can get ahead of the process by doing their own due diligence to identify and remove one-time income boosts, non-recurring expenses and other potential financial distortions. This way they can establish a fair value for the company and avoid price adjustments during the sales process.

Here are some issues for sellers to consider when preparing for a quality of earnings review:

  • Large non-recurring revenue sources, unusual gains or losses and sales of assets.
  • Variations between operating cash flow and net income. A company with a high net income and a negative cash flow is earning profits somewhere other than sales.
  • High sales growth based on a boost in credit sales, particularly sales from loose credit terms.
  • High customer concentration.
  • Refinanced debt into a future balloon payment, which increases net income in the current year but pushes the repayment down the road.
  • How the company accumulates its revenues, such as cash or non-cash, recurring or nonrecurring.
  • The impact of management changes on revenue and expenses.
  • External factors like high inflation, which can inflate sales figures.
  • Changes in accounting policies or aggressive accounting that projects a more favorable financial picture.
  • Pro-forma adjustments to capture critical reporting elements that may go unaddressed until the end of the fiscal year.
  • Methods of measuring earnings: Investors often use EBITDA, or earnings before interest, depreciation and amortization. But a free cash flow model may be better for some investors.

Sellers will reap many benefits by anticipating the quality of earnings review before it’s time to sell. Using due diligence to substantiate the company’s true earnings will not only support a higher purchase price, it will reduce uncertainty and reassure investors that they are making the right move.