What is Quality of Earnings?

Dr. Richard Thorndike : What is the rate of patient recovery?

Dr. Charles  Montague: Rate of patient recovery? I’ll have that for you in a moment (taps on his calculator)

Dr. Charles Montague: Once in a blue moon – dialogue from High Anxiety by Mel Brooks

In the world of transactions, there seems to be no phrase more misunderstood by entrepreneurs than Quality of Earnings. If you are a growing or mature business and are considering a possible sale, this should be a principal focus.  If you want to know how many companies have a successful sale without a solid quality of earnings, one need look no further than this scene from High Anxiety to get your answer. So, what is quality of earnings?

Perhaps the key indicator of what a buyer will pay for an established business is a sustainable cash flow. Most use the concept of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) as a proxy for cash flow.  Like anyone looking at investing money, all look for some indicator that there will be ongoing cash generated which will both pay off any debt borrowed to finance the deal as well as produce an appropriate rate of return.  Everyone also recognizes that any future cash flows are subject to varying degrees of uncertainty and risk.  A buyer has to assess various risks such as execution, market and political to determine the level and appropriateness of any offer they make.  Many believe that past operating history (appropriately defined) is a good indicator of future cash flow and thus, the concept of quality of earnings was developed many years ago.

Quality of earnings is a way of taking recent operating history and adding some color and/or adjustments to, in essence, “properly calculate” what past earnings (and cash flow) have been.  Once sanitized, the quality of earnings presents a more reliable indicator of past cash flow.  So, what are some of the items/issues that get considered for adjustment:

  • One off “windfalls” or non-recurring items of revenue
  • Non recurring income and expense – such as lawsuit settlements, etc.
  • Owners’ compensation – does it have to be adjusted (up or down) to what has to be paid for someone to run the business
  • Customer or vendor concentration
  • “Catch up” accounting adjustments

The focus on these points is one of the major reasons for what seems at times to be endless questions and analysis of past operating history during the due diligence process.

There are a number of less established businesses where earnings are not as much of a factor.  Those investors tend to focus more on other Key Performance Indicators (KPI’s) such as recurring users of an app, unique visits to a site, costs to acquire new users, etc.  While the focus is different, the objective is the same – trying to correlate past data in a way to predict future cash flow.

If you are contemplating a transaction, performing your own Quality of Earnings analysis with your professional advisor is a prudent first step.  It will allow you to focus on how an outsider will view your business and issues you may want to address to help ensure you maximize the value of your deal.

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