Quality of Earnings: A Key Pillar of Financial Due Diligence

Before entering into any transaction with another party, it’s important to do your own financial due diligence to confirm the facts. Are you really getting what you think you’re getting? Or have you found the next Luckin Coffee?

During financial due diligence (FDD), three pieces of analysis are key to determining the right price to pay for the deal:

1. Quality of earnings (QofE)
2. Net debt
3. Net working capital (NWC)

I refer to these tests as the three pillars of financial due diligence. At a high level, we are trying to locate items that relate to the normal course of business, capture material cash flows not captured in financial statements, verify the consistent accounting treatment of items, and ensure that items are recognized in the correct time period.

More often than not, an adjustment in any one of the pillars will impact items in the other two. As a rule of thumb, every balance sheet item related to lines above EBITDA should be part of NWC, while every item removed from QofE and NWC, with any actual cash impact in the current year or in near-term future, should be considered for net debt.

In a series of articles, I will delve deeper into how to perform these tests, starting here with quality of earnings.

Assessing Quality of Earnings in Due Diligence

Quality of earnings answers the salient question of whether a topline or cost line from the current year is from a principal business activity, or is just a one-off. Due diligence practitioners are therefore looking to ascertain what the normal and sustainable level of earnings is so as to ensure the multiple-based price being paid in the transaction is fair.

Of all the analyses in an FDD report, quality of earnings is perhaps the most closely watched, as enterprise value is often driven by FDD-adjusted EBITDA rather than the figure reported by management. A successful $100k reduction to EBITDA would translate to a $1 million reduction in price for a deal going at a 10x EBITDA multiple. Therefore, adjustments normally deemed immaterial are all under scrutiny due to their potential impact on price.

Examples of Quality of Earnings Adjustments

When looking at the types of adjustments that would be made during QofE analysis, the following are the most prominent that I have encountered in my work:

As you can see, there are elements in the table that correspond with the annual race to meet budgeted targets. Yet, when it comes to a transaction, the buyer is, more often than not, only concerned with the ongoing core operation of the business. Hence the need to strip out anything that is not a core component of “business as usual” activity.

Case Study: Fashion Retail

Let’s show the adjustments in action by walking through a case study example for a fashion retailer.

The acquisition target is Fashion X, a small retailer with 10 stores across the region. During the due diligence process, the following factors were determined:

• The company has a December year-end and adheres to IFRS accounting standards.
• 20% increase in EBITDA from last year
• Expected deal value to be 10x EBITDA
• The setup time for stores, from when stores are opened to when they get profitable, is estimated at six months. All setup costs are expensed above EBITDA.

• Three stores were opened at end of Sep-18 with the following details:

  Setup cost	Loss in first 6 months	Monthly profit after 6 months
  $10k	$50k	$5k
  $5k	$40k	$6k
  $5k	$10k	$4k

• One unprofitable store was closed at the end of Jun-19. The total loss of the store and the cost of closure was $100k in FY19. The store lost $10k in FY18.
• Year-end provisions summary shows unused contingency accrual reversed in current year, increasing EBITDA by $100k.

Breaking Down the Case

Due diligence is a forensic exercise where practitioners must parse information and focus on key points that emerge. Here are the key insights drawn from the case data that impact quality of earnings.

1. One-off store setup costs

For any business that can increase revenue by adding a discrete revenue-earning unit (e.g., a restaurant, retail outlet, production unit), it is fairly common for the unit to have a one-time setup cost. Often, these costs, to the extent they are expensed to P&L above EBITDA, are reversed within QofE as they are considered a one-off. In this case, the total setup cost over six months was $20k (10+5+5). Of these six months, three (Oct-Dec) are in FY18 and the other three in FY19 (Jan-Mar), therefore, the cost in FY18 and FY19 are both reduced by $10k.

In a deal, everything eventually boils down to negotiation, nothing is in black and white. If the business is expanding and it is normal to add 2-4 stores a year (i.e., it has been doing it consistently over the last few years), the buyer can argue that these are not one-off costs but are incurred in the normal course of business. This would knock off $100k from the deal price.

2. Six-month loss for new stores

Similar to setup costs, it is fairly common for a new unit to have a “ramp up” time and operate under loss during that time. This could be due to time spent in marketing, getting production to a minimum level, or putting together a successful store team. These initial losses are also reversed within QofE. The total loss over six months from Sep-18 was $100k (50+40+10), therefore, the costs in FY18 and FY19 are both reduced by $50k.

3. Annualized profit for new stores

Even though the retail unit lost money in the first six months of operation, it is an investment in the business that is expected to yield higher revenue, as is demonstrated by the stores being profitable subsequently. QofE numbers are adjusted to reflect this.

4. Loss-making store sale

The business that the buyer will get won’t have the loss-making store. Therefore, the cost incurred and the losses related to the business are reversed (FY19: $100k; FY18: $10k).

5. Contingent consideration timing

Businesses often end up under- or overestimating accruals, which can overflow into next year at year-end. When the actual invoice comes in, the management may need to adjust the accrual, leading to some cost recognition in the wrong period. This is perfectly acceptable from an audit or accounting point of view, but in FDD, we would adjust for it.

Why adjust for previous years when the final price would be based on the current year? This is done to get a better idea about the underlying growth story. Note that while the underlying earnings of the business are better than reported, the adjusted earnings grew only by 1.5%, compared to the 20% reported growth.

Taking the above into account, the quality of earnings table would look like:

As you can see, there are material changes to the “business as usual” figures as a result of the store expansion. The adjusted earnings show an uptick as these costs are added back, which in the resulting negotiations would give consideration toward a higher expected sale price.

A Word of Caution

Financial due diligence is not an audit and will not completely protect you against misinformation and fraud. However, it will make your case stronger and help you to negotiate a better price. On many occasions, deals are done on the basis of a strategic rationale, with FDD being of limited importance in such scenarios.

Conclusion

This walkthrough is intended to give a practical example of why QofE is vital during deal negotiations and how financial due diligence works in practice. In subsequent articles, I will explore net debt and working capital in a similar manner to complete the three pillars.

This should give you some idea about these value drivers in a deals scenario. However, these would need to be adapted to specific needs of a deal or a business, for which it would help to engage specialized consultants to chalk out a custom plan and put your best foot forward in deal negotiation.