Critical Success Factors of Quality of Earnings Reports

gearsandgraphsDuring an M&A event it is vital that the buyer knows as much as possible about the likelihood of consistent future earnings of the target (seller’s) company. Typically, the parties start these discussions by using the target company’s EBITDA (earnings before interest, (income) taxes, depreciation, and amortization). Yet knowing a company’s EBITDA is not enough to ensure that future earnings potential of the target company will reach the buyer’s desired goals.

EBITDA is used as the definition of earnings because it allows the seller’s performance to be measured and understood more easily, relative to other earnings measures. It also allows a company’s value to be considered separately from the influence of capital structure and certain accounting policies, which reflect management decisions that may vary greatly between the seller’s history and the buyer’s plans.

Buyers, however, need to know much more about the sellers’ earnings than can be obtained by taking the reported information at face value. The buyer of a corporation expects to get a much clearer picture of the seller’s earnings by exploring the story behind those earnings. A prudent buyer performs a “quality of earnings analysis” of the seller to answer the question, “What makes this company’s earnings ‘quality?’”

Among the characteristics to consider are these:

  • Do the earnings (EBITDA) reflect the seller’s company’s ability to produce cash flow?
  • How sustainable and repeatable are the earnings?

Free Cash Flow as an Indicator of Future Earnings

EBITDA may be the driver of value, but it is important to understand fully the net working capital (NWC) requirements for the company to generate its earnings. The buyer needs a crystal clear picture of the reconciliation of the EBITDA to the free cash flow (FCF). The NWC requirements are the change in current assets minus the change in current liabilities. Current assets such as inventory and accounts receivable will typically increase as the company’s revenue grows, as will various current liabilities.

The buyer must also gain an understanding of the cash flow levels that will be needed in order to fund its growth plans. For instance, will the buyer get the same trade terms and pricing from key suppliers that were available to the seller, or were special agreements in place that will not be continued? Will the buyer wish to modify any terms that the seller offered to its customers? What were the seller’s inventory policies, and will the buyer need to make substantial changes (positive or negative) to the inventory levels on hand?

Furthermore, the buyer must factor in the capital expenditures required to sustain earnings in the future. For example, oil and gas production companies have significant capital spending budgets in order to sustain their earnings in the future. The cash spend for oil production is a major part of understanding the FCF for an oil and gas company. It will be important to understand the age, efficiency, and quality of the seller’s capital assets in order to confirm that those assets will continue to produce earnings for the company on an ongoing basis.

The impact of revenue recognition could also cause issues with the buyer’s attempt to reconcile earnings to FCF. It is critical to have a clear understanding of the revenue recognition issues that might be present in the seller’s financials.

Hidden Issues with a Seller’s Earnings Sustainability and Repeatability

Earnings sustainability refers to the buyer’s ability to generate revenue consistently at the same level the seller has historically achieved, within the same cost structure. The following questions must be addressed to determine sustainability:

  • Are future revenues likely to continue at the historical levels?
    • Will the buyer have the same or equivalent resources in place to make sure sales will continue to occur?
    • Is there consistency and competence in the sales team, the customer service team, and the distribution network?
    • Is there a sales concentration with a customer that may have ulterior motives for doing business with the seller (such as a close personal relationship)?
    • Is there any new competitive pressure in the market that may not have been encountered historically?
    • Does the seller have any large, non-recurring sales that serve to inflate the historical sales numbers beyond what can be repeated?
    • Is the company producing an outdated product or service that might not keep pace with changes in the industry?
  • Could the seller have engaged in schemes such as “channel stuffing,” whereby companies sell unrealistic amounts through to distributors who have more product than they will sell in normal business cycles?
    • Are gross margins sustainable given the current state of the company and the industry?
    • Are there pricing pressures that will compress margins?
    • Are costs of goods (or services) sold (COGS) (that is, raw material or manufacturing or service costs) stable for the foreseeable future?
    • Are COGS accounted for accurately, or are there buried costs on the balance sheet?
  • Are operating costs reported accurately given the operations?
    • Do the operating expenses reflect all costs truly required to run the operation? Are these costs appropriately accounted for in the P&L?
    • Has the seller been deferring maintenance spending to keep operating expenses low?
    • Has the seller made the appropriate investments in infrastructure (such as IT systems and technology) that will enable the company to sustain the same level of earnings in the future?

The buyer also need to evaluate the seller’s ability to repeat its earnings performance. The buyer should expect the seller to produce a forecast for at least the upcoming 12 months—a three-year forecast would also be a realistic expectation. This will be a good measure of the seller’s management’s ability to articulate its vision for the future and to recognize future events that could affect the company. During the process of evaluating the forecast, the buyer will have a good opportunity to assess the quality of the management team it will be inheriting.

The seller’s earnings also typically have economic factors or other outside influences that impact the company’s performance. If the company is in an industry that relies heavily on commodity pricing, such as the oil services industry, the success of the company may be closely tied to the price of the related commodity.

In summary, the quality of earnings analysis is a way to dig into each of the reported aspects of the seller’s operations and to understand in-depth the balance sheet accounts and the impact on the earnings and cash flows of the business.