You’ve just signed a letter of intent to acquire a business. Now what?
Typically, a letter of intent provides a 60-90 day exclusivity window for the buyer and seller to perform various forms of due diligence, including (but not limited to) financial and legal. Having a third-party advisor perform financial due diligence regarding an acquisition not only helps determine a fair purchase price and deal structure, it also results in a greater understanding of what it is you are buying. In performing financial due diligence, a quality of earnings analysis is strongly recommended to properly assess the financial stability of the target company.
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A quality of earnings analysis is based off a target company’s historical financial statements in which EBITDA (earnings before interest, taxes, depreciation, and amortization) is normalized for one-time, non-recurring, non-cash, and non-operational items. The analysis will typically involve the review of at least three years of historical financial information with the main focus being placed on the trailing twelve month period. The result of the analysis is an adjusted EBITDA figure that shows the sustainability of the target company’s earnings stream.
Common adjustments to EBITDA include:
- Owner discretionary costs
- Historical vs. future ownership compensation differences
- Excessive or one-time professional fees
That being said, the quality of earnings analysis frequently results in other adjustments, some of which may not be as obvious to someone without extensive transaction experience.
Listen to episode 173, “Back To The Basics Of Business Valuations,” featuring Rea’s director of valuation and transaction advisory services, Mary Beth Koester on Rea’s award-winning podcast, unsuitable on Rea Radio.
As an example, diligence adjustments that may not be known prior to the analysis can relate to differences between month-end and annual closing procedures, revenue recognition or improper capitalization of inventory. An illustration of these types of adjustments might be if a company were to record an annual employee bonus or physical inventory count adjustment once a year at year-end, it can result in an over or understatement of EBITDA depending on the trailing twelve-month period end.
In addition to a quality of earnings analysis, it’s typical to analyze monthly net working capital trends and customer, product, and/or service concentration risks.
Because most transactions include a networking capital mechanism, it’s important to understand your target company’s net working capital seasonality and determine if any normalizing adjustments should be made to ensure a fair target amount is in place for all parties at closing. Concentration risk analyses can help you understand the target company’s most significant customers and products, while also illustrating areas of further expansion or development.
As the financial due diligence process is performed, your advisor may uncover items that are absent from a target company’s financial statements. The most common examples are various compensation and vacation/PTO accruals as well as inventory costing or reserve issues. When you discover such items, they should be included as a consideration in the calculation of adjusted EBITDA and the resulting purchase price, which is often expressed as a multiple of adjusted EBITDA.
Acquiring a company takes a lot of effort, expertise and time. Third-party advisors can help alleviate these items, which will allow you to focus on your other, more important tasks – like ensuring that your company continues to operate efficiently and effectively. Having a greater understanding of the company you are looking to acquire will help ensure an accurate valuation and that you are well prepared to meet the goals you and your team has set for the potential acquisition.
Are you thinking about acquiring a business and have questions related to the process? Contact Rea’s valuation and transaction advisory services team for assistance and insight.
By Mike Schultz, CPA (Dublin office)