Why Quality of Earnings Matters When Selling Your Business
When selling a closely held business, one thing that’s sometimes overlooked by owners and CEOs is their company’s quality of earnings. Because when it comes to corporate earnings, they aren’t all created equal.
The most common measurement of corporate earnings is an acronym referred to as EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This is considered to be an accurate reflection of earnings because it strips out the financial impact of interest, taxes, depreciation and amortization. But further adjustments may also need to be made to give buyers a more accurate view of a company’s true earnings.
Earnings & Free Cash Flow
Determining the qualify of earnings will reveal how close your business’ earnings are to your actual free cash flow. Earnings and cash flow can be considerably different due to certain accounting practices like depreciation of assets, inventory accounting and working capital needed to sustain accruals.
Quality of earnings refers to how much of your business’ income is generated as a result of core operating activities. The main factor in whether earnings are considered to be of high quality is your company’s ability to influence earnings. If you can boost earnings by increasing sales and revenue or decreasing costs, then you generally have high-quality earnings. Conversely, if your earnings are mainly influenced by external events or internal accounting practices, you generally have low-quality earnings. These latter events and practices may include:
- Aggressive accounting practices
- The sale of assets for gain
- Elimination of LIFO inventory
High-quality earnings are readily repeatable in the future, instead of just short-term, unsustainable bumps caused by temporary factors or a one-time event. Companies with high-quality earnings also usually engage in conservative accounting practices that appropriately recognize all relevant expenses in the right accounting period and don’t artificially inflate revenue.
Making Earnings Adjustments
Business buyers will usually make adjustments to EBITDA to arrive at a more accurate earnings number. For example, earnings should be adjusted to account for the following:
- The owner’s personal luxuries like a yacht, vacation home or country club membership.
- Relatives who are on the payroll but not doing much actual work.
- Excess accounts receivable that aren’t likely to be collected.
- Dead inventory that’s not likely to be sold.
- Overlooked one-time expenses.
- Under-recorded or unrecorded liabilities.
- Accounting errors.
Earnings should also be adjusted to account for debt and debt-like items that could affect future cash flow. These may include underfunded pension plans, deferred compensation plans and pending legal or regulatory disputes.
One way to improve the quality of your business earnings is to have a quality of earnings study conducted before putting your business on the market. An independent financial professional will closely examine your company’s earnings and make appropriate adjustments like those discussed here. This will give buyers greater assurance that your stated earnings are viable and sustainable, which can help boost your business’ selling price.
One thing that’s sometimes overlooked by owners when selling their business is the quality of their company’s earnings. Quality of earnings refers to how much of your business’ income is generated as a result of core operating activities. If you can boost earnings by increasing sales and revenue or decreasing costs, then you generally have high-quality earnings. You can improve the quality of your earnings by bringing in a project CFO with proven expertise in conducting a quality of earnings study and recommending the right adjustments to accurately reflect earnings for potential buyers.
Arthur F. Rothberg, Managing Director, CFO Edge, LLC