Earnings quality: It’s the buyer’s right to know

November 28, 2017 John D. Wagner

Everyone wants to sell their business at peak earnings. Who wouldn’t? Since most businesses are purchased as a multiple of earnings, you as a seller have substantial motivation to get those earnings as high as possible (on a trailing-twelve-month basis or previous-fiscal-year/ calendar-year basis) before you put your company up for sale. Every dollar added to Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) can bring back a 5X, 6X or even a 7X return in valuation.

Most prospective buyers expect to see this pattern of selling on an uptick. It’s only natural; indeed, any business that tried to sell at a low in the business cycle would be looked upon with suspicion, and it would accordingly receive a poor valuation.

But buyers that are considering companies selling a time of peak earnings have the right to question two things: the quality of those earnings in the past, and the sustainability of those earnings in the future.

Quality of the earnings. The quality of the earnings is an indication of how repeatable they are and how likely they are to continue. High-quality earnings don’t necessarily have to show up on your books as repeat business, although that is certainly desirable, since repeat business costs the least to acquire. In fact, high-quality earnings can be represented by simply occurring at consistent levels (or consistent rates of increases), year for year, whether the source is repeat business or new business. High-quality earnings point to a quality sales staff, and a disciplined company that works hard to take care of its customers.

Let’s look at an example. Let’s say a business shows sales of $25 million three years ago, $27 million two years ago, $29 million last year, and a prediction of $31 million this year. Let’s also say that the company has consistently shown 10% EBITDA margins, with an unadjusted EBITDA of, respectively, $2.5 million, $2.7 million, $2.9 million, and a projected $3.1 million this year.

A prospective buyer looking at that company will have no problem believing the current fiscal year’s projections, even with just a few months of data to go on, because the earnings have shown consistent high quality and growth.

If another business were to show jagged sales and EBITDA margins that bounce around year for year, with no symmetry, followed by a killer year of strong sales and high EBITDA margins, the potential buyer isn’t going to have a great deal of faith in a recent, spectacular 12-month period. That’s because the recent numbers may not represent a trend that will continue. In fact, they are likely to represent a “sugar high” that can’t be consistently replicated. Red flags will pop up on the deal, and valuation won’t be based in the trailing 12 months, but perhaps on earnings averaged out over the past three years.

Sustainability of earnings. Simply put, the sustainability of earnings indicates if the current earnings are likely to continue at roughly the same Cost of Goods Sold (COGS) expenditure levels.

It’s even more impressive if you can show that you can sustain or increase your earnings while lowering COGs over time, showing that you are always working to drive up efficiency.

If you had a great year, but you know in your heart that you will have to increase marketing costs and salaries the following year to retain those customers, then the sustainability of the earnings is lower, and your customer retention may be more a volatile than current earnings indicate.

The same principle holds true for a seller who positions his company for sale by making an effort to suppress COGS by deferring maintenance that needs to be done, or by not filling a position that he knows needs to be filled, or allocating expenses in a different time period than the allocation of earnings, just to obtain an earnings credits that really should be an expense.

Accordingly, a prudent buyer will examine your COGS, your maintenance schedules, and your historical staffing levels/future staffing needs, and see how they have changed over time with respect to your earnings.

Finally, if you have earnings that you have recognized yet not collected, (e.g. pending AR) and you are using an accrual accounting basis, you will have credited those to EBITDA. Yet the prospective buyer will be within his rights to question if those are truly earnings, especially if there is a history of bad pays that have not properly been accrued for in your allowance for bad debt.

No tricks. There is no trick to stating the quality and sustainability of earnings. It’s about divulging what’s fair and reasonable, properly allocating earnings and expenses, and being forthright in calculating COGS in a way that buyer and seller agree is accurate.

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