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Earnings quality affects business value upward or downward

Scott Wait

A helpful tip for business owners preparing to sell their companies within a two- to four-year time frame is to review their company from an outside buyer’s point of view. An outside buyer is interested in reviewing the quality of the company’s earnings.

An analysis that business buyers employ when scrutinizing a purchase is the quality of earnings. Earnings are earnings — right? Well there are distinctions between high quality and low quality especially when third parties look at your earnings. Many of the best practices discussed below improve (drive up) your business value even though you may have no plans of selling in the near future.

Quality of earnings review is part of the due diligence phase of business sale negotiations. Quality of earnings analysis and regular review of it allow you to grow sustainable, predictable earnings and cash flow which, in turn, grows one of your largest investments — your business.

It is important to remedy weaknesses as perceived by outsiders such as potential buyers ahead of the time before your business would be under intense scrutiny by the third party. This review may find issues that buyers would use to negotiate discounts to the company’s value in the final agreement.

A typical review is conducted after a letter of intent is signed by the business seller and prospective buyer. The analysis is either conducted by the buyer or its due diligence firm, usually an accounting firm, which is focused on verifying the earnings generated by the business and identifying expenses that the buyer may not incur or include future expenses that the buyer will incur to continue generating the earnings as reported by the target, seller company.

Quality of earnings reviews may uncover certain issues, such as:

1. Earnings diversity/concentration is an important value driver or business risk from an outsider’s view point whether they are potential investors, buyers, or even lenders. A company that has customer base in which no single customer comprises more than 5 percent of total revenue is a common definition of diversified customer base. A diverse customer base give comfort to investors and potential buyers. It implies that the company has stable revenue sources because, if and when, any given customer is lost, your revenues will not be severely affected by the loss. Of course, there should be a solid, sales system in place to grow your company and replace non-renewing customers as well.

2. Recurrent revenue stream reflects a high quality of earnings. Businesses that have solid, predictable recurring revenue sources are considered more stable and attractive to outsiders including investors, buyers and lenders. With high recurrent revenues, a business is more able to navigate seasonal fluctuations in the business cycle and are more attractive to buyer as long as the recurrent revenue have healthy profit margins.

3. Revenue or expenses reported in incorrect periods. There may be timing differences in how these items are reported that the reviewer will point out. It’s best to follow generally accepted accounting principles to minimize the findings and questions.

4. Accrual accounting errors or inconsistencies. In addition to the previous point, revenues and expenses should follow the accrual method, revenues reported when earned, and expenses reported when incurred. If the company is using cash method or a modified method, it will give pause to the reviewer and raise concern of an informed buyer, because the records would not be reported in the standard, accrual method of accounting: The buyer may not trust the accounting records if there are significant anomalies to these standards. It’s even better to have the accounting records audited or reviewed by a CPA firm to present to third parties.

5. Unfilled employee positions or missing expenses. The reviewer also analyzes your staff positions and regular expenses that are part of your direct costs or overhead expenses. Are you under staffed in certain positions? Are there obvious expenses not shown on the income statement that similar companies normally report? The reviewer uses ratio analysis tools, by department when available, to determine how your company compares to competitors. If there are unfilled positions or missing expenses, the reviewer will adjust your income downward to benchmark to similar companies. When they find unfilled positions or missing expenses, the reviewers downwardly adjust earnings and effectively drops your business’ value.

6. Quality of earnings should include industry comparison of your sales to expense ratios such as sales to direct costs and sales to selling expense and sales to general and administrative expenses. Industry and competitor ratios are commonly found in trade association databases for their members. The reviewer and interested third parties will rate your earnings positively when the ratio analysis results meet or exceed industry standards: they will see signs that your company is run effectively and efficiently compared to your competitors.

A regular review of your earnings quality is helpful for not only owners getting ready to sell, but it also is a good practice to ensure that you are growing a predictable, healthy bottom-line that provides for your family and your employees for the sustainable future.

Scott T. Wait, CPA, a partner with RS Wait, welcomes your questions or comments at 775.825.7337 or scott@rswait.com; http://www.rswait.com.