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Quality Check Your Investments

12/05/2014


This article was originally published in PCMA Private Capital Markets Magazine, Spring 2014

Thorough investigation into the quality of earnings helps buyers decide if the price of a business is right.

When it comes to buying a business, paying too much for it can have serious ramifications, affecting financing along with the future revenue of your business. That’s why it’s so critical to understand whether the amount of earnings the vendor is claiming the business earns is sustainable—and the quality of those earnings—before you finalize the deal.


Being aware of the quality of earnings isn’t just about looking at the numbers, although that’s an important indicator. It requires developing a thorough understanding of the target’s business.

“We spend several hours talking with management of the target company before we even look at the detail behind the financial statements,” says John Caggianiello, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto.“That conversation gets us the information we need to determine the risk areas for our client: the corporation or the Private Equity firm planning to buy the business, or the Bank or alternative lender wanting information for decision-making purposes.”

Various areas of the business are explored in the meeting, such as how the target company acquires customers, how sales are made, what kind of capitalization policy is used and how inventory is handled. “You also want to ask questions that can bring things to light that you’d never otherwise discover, such as what keeps them up at night or how they would grow the business if money was no object,” says John.

The idea is to learn how the business operates so that financial, customer and vendor analyses can be done with an understanding of where the risks lie. “A quality of earnings review doesn’t need to look at every single little thing. That’s not cost- or time-effective,” says Vic Kroeger, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto. “You need to look at the right things. We tailor the investigation to focus on specific areas, those of highest risk for the buyer.”

While the process always involves pinpointing certain areas, how you look at those areas will change depending on the type of business. For example, Accounts Receivable Aging will always be examined but, says Vic, if you know, through a conversation with the management of the target company, that one customer makes up 75 per cent of sales, you can focus your work on how quickly that customer pays, calculate the percentage his purchases have increased or decreased, determine how vulnerable the company is to their existing orders, etc. and perform a cursory review on the rest.

Uncovering The Truth
Every quality of earnings investigation turns up something the buyer is better off knowing. If it impacts the value of the business, the buyer and vendor are usually able to renegotiate the deal in the buyer’s favour.

The buyer can benefit even when information is uncovered that would raise the price of the business. “On one file, we found a $150,000 error to the seller’s advantage,” says Vic. “If the seller knew about it, he could have increased the price by the five times multiple totalling $750,000.” But the seller didn’t get to read the report the buyer had engaged MNP to complete. “That meant the buyer knew they were getting a deal and had $750,000 in their pocket to negotiate with,” says Vic.

Even serious issues can be resolved if they are brought tolight before the deal is finalized. In one case, the vendor’s General and Office category in the financial statements jumped from $5,000 one year to $30,000 the next. Delving in, MNP discovered that overtime was being put into General and Office because the company was paying cash.

Had the buyer purchased the business unaware of this fact, potential tax issues, issues with the union, or even a lawsuit in the future could have been costly. Such serious issues often cause a deal to fall apart, but in this case, a solution was found. “The vendor left more money on the table, in the form of a take-back note, just in case there was future exposure,” says Vic.

In some cases, information about quality of earnings is uncovered that drastically reduces the value of the company. John offers the example of a seller claiming $1 million of normalized earnings; the buyer agreed to pay $5 million based on those earnings. But due diligence uncovered a significant cut-off problem: the vendor was pre-reporting revenue, entering sales into the year on which the price of the business was based instead of in the year when the revenue was actually earned. Taking out the prerecorded revenue resulted in a 40 per cent decrease in earnings.

The deal didn’t go through, but the buyer avoided a host of problems. “If we didn’t go in, the buyer already had assumed that the accounting records were being reported properly, and would have done the deal. And next year, when the financial statements were done properly, there would have been a big surprise that would have put him offside on all his financial covenants with his lenders,” says John. “He could have lost the business.”

While it’s possible to have your internal accounting team check the quality of earnings, John warns that there are certain instances when it’s important to have an independent third party specializing in transaction advisory do the work for you. This is especially important when you are seeking financing.

Using a third party is also an efficient way to get a labour intensive process completed without draining your internal resources. Performing due diligence often takes two to three weeks to complete and involves working long days. Buyers also need to consider what they will do if a serious issue is uncovered, as they will want to access the right advice to renegotiate as quickly as possible.

Done properly, due diligence to check quality of earnings is like insurance for buyers. Accurate information in hand, they can understand the issues ahead of time, renegotiate the deal based on the earnings that are really there and complete the transaction successfully.