A company can report a strong profit while still creating concern for a buyer.
The issue may be revenue timing, temporary cost reductions, unusual customer activity, owner-related expenses, weak cash conversion, or one-time events.
A quality-of-earnings review examines how closely reported performance reflects the company’s normal and repeatable operations.
It is not the same as an audit, valuation, or legal review.
Recurring and nonrecurring performance
Management should distinguish between earnings generated through ordinary operations and earnings affected by unusual events.
Examples may include:
- one-time customer orders;
- insurance proceeds;
- government support;
- temporary supplier discounts;
- legal settlements;
- asset sales;
- unusual professional fees;
- owner-related expenses;
- temporary vacancies;
- exceptional market conditions.
Adjustments should be reasonable and supported by evidence.
Removing every unfavorable expense while keeping every favorable event is not normalization.
Revenue recognition
A buyer will assess whether revenue is recorded in the correct period and supported by completed delivery or enforceable contract terms.
Questions may include:
- Was the product delivered?
- Was the service completed?
- Does the customer have acceptance rights?
- Can the customer cancel?
- Are credits or returns likely?
- Was revenue accelerated near the end of the reporting period?
- Are contract liabilities properly recorded?
Weak revenue cut-off can materially change the view of performance.
Gross-margin consistency
Revenue growth has limited value if gross margin is unstable or poorly understood.
Management should be able to explain margin changes by:
- customer;
- product;
- service;
- market;
- project;
- channel.
A decline may result from pricing, input cost, delivery problems, customer mix, discounting, or inaccurate allocation.
Cash conversion
Earnings that do not convert into cash require explanation.
Review:
- receivables;
- inventory;
- supplier payments;
- customer deposits;
- deferred revenue;
- capital expenditure;
- overdue invoices;
- unbilled work.
A profitable company with weak cash conversion may require more capital than the income statement suggests.
Working-capital requirements
Transaction discussions often focus on how much normal working capital the business needs at closing.
Owners should understand:
- seasonal patterns;
- inventory needs;
- customer payment behavior;
- supplier terms;
- growth-related cash requirements;
- unusual balances.
A temporary reduction in working capital before a sale may not reflect the normal needs of the business.
Owner and related-party items
Privately held companies may include expenses or arrangements connected to the owner.
These can include:
- compensation;
- vehicles;
- property;
- related-party rent;
- family employment;
- shared services;
- personal expenses;
- loans.
These items should be documented and treated consistently.
Prepare before the process
Owners should not wait for a buyer’s adviser to define the company’s earnings.
Management should prepare:
- monthly financial statements;
- reconciliation to statutory accounts;
- explanations of major variances;
- support for proposed adjustments;
- customer and product margin analysis;
- working-capital history;
- cash-flow information.
Quality of earnings is ultimately a test of whether the company’s reported results can be understood, supported, and expected to continue.