Quality of earnings is an important indicator of the value of your company, but that is one facet of its significance. A high quality of earnings improves your credit standing with your bank, providing greater borrowing ability and faster loan access at critical times. If you are considering buying or selling, it enhances your business’ appeal. Alternately, if your company is an ongoing concern, it enables you to pay dividends to shareholders even during economic downturns.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is tightly connected to quality of earnings. This predictor of the cash flow generated by a business has become the language of buying and selling businesses. When we talk about quality of earnings and EBITDA, the quality of those earnings is as important as anything else we measure.
There are both positive and negative attributes to consider in determining your quality of earnings:
1) Sustainability. A documented history of growth and stability is the most critical attribute. Growth spikes alone are not enough; they must be proven sustainable over a reasonable period of time and be perceived as continuing into future years.
2) Equipment and technology. Machinery that is technologically current for a company’s market niche and has a good maintenance program can enhance your quality of earnings. A reasonable amount of excess capacity must also be present to accommodate future growth. In buy/sell situations, outdated equipment is perceived as cause for future significant investment, so buyers are likely to discount the value of earnings.
3) Good management team. Companies with strong management capability and depth can continue successful operations, even if unexpected circumstances impede management operations. A business run by a single critical manager is perceived as much more vulnerable, so quality of earnings is negatively impacted.
4) Real estate. Rent that is below market value may seem like a positive attribute, but realistically, that rent will increase at some point to full market value. The savvy buyer recognizes this and, therefore, discounts quality of earnings accordingly.
5) Business cycles. Selling a business at the beginning of a projected economic downturn or when future sales are questionable can negatively impact quality of earnings. If positive business trends are expected to continue for three to four years, quality of earnings gets a positive boost.
6) Fluctuation in earnings. If a company’s earnings have spiked to the 100’s after years of being in the 50 range, there is actually a negative impact on quality of earnings, at least until the higher numbers are proven to be sustainable over a reasonable time frame. Sellers experiencing fluctuation in earnings may get more than their historic 50—but not the full 100—until sustainability can be proven.
7) Sales concentration. We have often seen highly successful printers with a single customer comprising more than 15 to 20 percent of total sales, or with their top three customers comprising more than 40 to 50 percent of total sales. These companies are more profitable because they have optimized their efficiencies in successfully servicing a particular market segment. Paradoxically, the increased productivity benefit of customer concentration can negatively impact quality of earnings. Buyers perceive customer concentration in terms of potential customer and revenue loss, so quality of earnings is negatively impacted. That same risk applies when a single salesperson covers 50 percent or more of the customer base.
8) Balance sheet. There are multiple line items that can impact quality of earnings. Each should be carefully examined during the due diligence period:
a. Accounts receivable, especially those more than 90 days old
b. Excessive credits
c. Age of work in process