At its core, buying a middle-market business is no different than any other investment decision: a basic function of risk and return. Potential buyers generally value a middle-market business based on expected future cash flows (returns) and the likeliness of achieving them (risk). Because future cash flows are uncertain, buyers typically use historical or projected earnings (i.e., EBITDA) as a proxy. A quick and easy way to value a business is to multiply the company’s earnings (returns) by a market-based multiple (to achieve a desired rate of return to account for risk).
Because a company’s value is generally calculated based on its earnings, its crucial to validate the Quality of Earnings (QofE) of the underlying business. In M&A terms, a QofE is a formal third-party engagement that analyzes the historical financial results and earnings power of a business. Receiving a well-executed QofE report from an experienced advisor helps to validate the authenticity and sustainability of reported earnings to a buyer and its investors, lenders, and other stakeholders.
QofEs are very common in today’s middle-market M&A environment. Throughout this article we will highlight the basic “A, B, Cs of QofEs”.
A: Accrual method of accounting.
The first letter in our A, B, C’s stands for “Accrual”. The accrual method of accounting is a common practice where revenues and expenses are recognized when the company’s performance obligation is satisfied or incurred, not when cash exchanges hands. Accrual accounting is a foundation for Generally Accepted Accounting Principles (GAAP) in the United States. One basic function of a QofE is to gain comfort that the company’s financial statements are following GAAP (i.e., revenue and expenses are matched and recognized in the proper period, accounting estimates are properly determined and applied, costs are either properly expensed or capitalized, etc.). Manipulation or inappropriate application of accounting practices could have a significant impact on a company’s earnings. Therefore, it is critical to analyze a company’s reported earnings for any accrual or GAAP-related adjustments.
B: Business model and industry dynamics.
A company’s quality of earnings is influenced by the nature of the business and the industry in which a company operates. Different industries have varying levels of earnings volatility, capital intensity, and seasonality, which can impact the quality and sustainability of reporting earnings. Understanding the specific dynamics of a company’s industry and its business model is crucial for assessing the reliability of its earnings. A company with a stable and predictable business model is more likely to generate high-quality earnings compared to one operating in a volatile or cyclical industry. A quality of earnings report can help highlight these business dynamics to allow investors to make informed decisions.
C: Cash flow (recurring).
The “C” in our A, B, C’s stands for “Cash flow,” specifically recurring cash flow. As noted above, cash flow or, by proxy, earnings/EBITDA, is typically the basis for a company’s valuation in an M&A transaction. While reported earnings might paint a general picture of the business, examining the true, recurring, cash flow/earnings of a business is essential. It is not uncommon for a privately held business to incur various non-recurring income or expenses, and owner-discretionary items (i.e., personal expenses running through the business’s income statement). A QofE engagement identifies these non-recurring and discretionary items and illustrates what the company’s adjusted earnings would look like if these items were removed. The result can either be an increase or decrease to the reported earnings of the business, which is important for a buyer to be aware of when contemplating a transaction.
Another common “test” performed during a QofE engagement is a Proof of Cash. A Proof of Cash reconciles a company’s reported revenue to its bank deposits. A Proof of Cash is a good indicator of whether a company’s reported revenue is being converted to cash.
Final Thoughts
In conclusion, the A, B, Cs of Quality of Earnings encompass the evaluation of accruals and accounting practices, consideration of business model and industry dynamics, and understanding a business’s true recurring cash flows. By engaging the right advisors to delve into these factors, potential buyers and investors can gain valuable insights into the reliability and sustainability of a company’s reporting earnings, enabling them to make well-informed investment decisions.
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