The most common report requested by potential buyers is a “quality of earnings” report or engagement. The objective of a quality of earnings engagement is to assess the sustainability and accuracy of historical earnings as well as the achievability of any earnings projections. A quality of earnings report provides a detailed analysis of all the components of a target business’s revenue and expenses.
The analysis should present a “normalized” EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) figure. (For more on that topic, see our previous article that compares EBITDA to Cash Flow). The term “normalized” in the context of EBITDA means that one-time or extraordinary items, excessive amounts and non-business items are either added-back or subtracted from EBITDA to show the “true” or “normal” operating income of the business.
An example of a simplified Quality of Earnings Report with “Normalized EBITDA" is presented below:
Many privately-held businesses are tax-motivated and will have many “add-backs” to their “normalized EBITDA”. The business owner will want to include as many tax deductions in the on-going business to minimize the tax they will owe each year. But when it comes time to sell the business, the owner (“seller”) will want to “add-back” these deductions to maximize the value of the business.
The most frequent “add-backs” that we see related to this “tax-motivated seller” strategy include:
These types of “add-backs” will typically be presented by the Seller or the Seller’s broker in their offering memorandum. These “add-backs” need to be assessed during the due diligence process for proper treatment and valuation.
Keep in mind that this is only one of many items that can be uncovered during the financial due diligence process. In our next article we will discuss other common findings when performing “buy-side” financial due diligence in the acquisition of a privately-held business.
For another blog post on this topic, check out:
Advice for First-Time Buyers by Lloyd Bell, Director of our Corporate Finance Group