Financial Due Diligence

Introduction The term “QoE” pops up often in business acquisition, but what is a quality of earnings report? When acquiring a business discerning the genuine financial health of a potential acquisition is a key part of good due diligence. This is the role of a Quality of Earnings report. The Quality Of Earnings Report A Quality of Earnings report is not merely a reflection of a company’s profitability. It’s a meticulous analysis that goes beyond superficial numbers, revealing the sustainability, consistency, and reliability of a business’s earnings. For a shrewd entrepreneur, the QoE is a guard against potential pitfalls and a guidepost to promising acquisitions. Why You Need A Quality Of Earnings Report Most companies selling for less than $5M do not have properly maintained financial statements. That being said, even properly maintained financial statements don’t tell the whole story of a company. A Quality of Earnings report focuses on whether or not historical revenue and profit will continue into the future. That is what you really care about, because that future cash flow is what you will depend on to pay down your debt, feed your family, and grow the business. Now, let’s look in more detail at what makes up a QoE report. What Is The Scope Of A Quality Of Earnings Report? A Quality of Earnings report is a consulting engagement and does not have any explicit standards from the American Institute of Certified Public Accountants (AICPA) on the exact processes or deliverables that should be included. That being said, here are a few of the issues that analysis performed in a Quality of Earnings may uncover. Improper Accounting If a company is not adhering to Generally Accepted Accounting Principles (GAAP) they may not be properly representing their financial results. Customer Concentration Revenue is of a higher quality when it comes from a variety of different sources. If all of the revenues for your target are concentrated in one or two customers there could be substantial risk to you as a buyer should one of those customers leave after you purchase the company. Supplier Concentration If a company relies on a single supplier for key resources needed to perform operations then they are at risk of that supplier raising prices, or having supply chain issues. Improper EBITDA Adjustments Just because the seller and their broker say something is an add-back doesn’t make it an add-back. Trust but verify. Related Party Transactions If any employees, customers, or vendors are related to the seller in any way it is possible that the relationship or dealings between the business and those key stakeholders may be different with you as the new owner. Revenue Or Expense Anomalies Some of the expenses or revenues in the historical period may not have occurred in the “normal” course of business. For this reason they should be adjusted out. Sustainability Of Future Earnings The past is not guaranteed to repeat itself. You want to understand how likely earnings are to continue into the future with you as the new owner. Divergence From Industry Benchmarks If the company you are buying has significant differences from industry benchmarks you’ll want to understand what is driving the difference. Recent Developments If something has changed in the business recently such as hiring a new employee, new pricing from a key supplier, or the addition of a new product line you’ll want to know about it. By uncovering these items, you’ll have a comprehensive view of the quality of the earnings you are buying. Profits Vs Quality Of Earnings The broker wants you to think the profits shown on the confidential information memorandum (CIM) tell you everything you need to know, but it will rarely tell the whole story. A Quality of Earnings report will. It dives into revenue consistency, expenditure trends, and filters out anomalies that could skew perceptions. Starting With EBITDA You’ll often hear the term EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) when talking about Quality of Earnings. It’s a foundational metric in the process and removes the distractions of taxes and other expenses. However, a Quality of Earnings report will go beyond just showing a clear view of EBITDA over the historical period. It will include adjustments for non recurring items, differences in accounting methods, and proforma changes that are expected to occur with a new owner. At Midwest CPA, our financial due diligence services analyze EBITDA, and other key financial data that will give you a normalized view of the financials so you know what you are buying. What Are “Normalized” Financials? When buying a business you want to know what financials will look like under normal circumstances with you as the new owner. For example, if the current owner of the business you are buying is getting a 40% discount on the rent for their office because their brother owns the building you would want to “normalize” this rent payment by looking at the financials as if the business had been paying fair market value. In short, “normalized” financials take a company’s earnings and strip away all the unusual stuff. Those things can make the company look more profitable than it usually is. By “normalizing” the financials, you get a clearer picture of how the company would be performing with you as the owner. How To Read A Quality Of Earnings Report A Quality of Earnings report may be structured in a variety of different ways. That being said, the below example shows a common layout that we use at Midwest CPA. Management Adjustments Oftentimes you will find on the CIM that management has already come up with their own adjustments to EBITDA. Management Adjustment Reversals During financial due diligence each of these adjustments will be reviewed and either validated or dismissed. Reclassification Adjustments These adjustments are for items that should not be included in EBITDA in the first place. For example, interest may have been included in total revenue and will need to be adjusted out. Normalization Adjustments These adjustments take

Back to Learning Center Introduction So, you’re in the market and wondering how to buy a business? Great choice! Acquiring an existing business can offer you immediate cash flow, a proven track record, and a faster path to profitability. As a specialist acquisition CPA firm, we’ve seen the benefits for our clients. In this post, we will walk you through the process of how to buy a business, from finding a business to financing, due diligence and more. Franchising vs. Buying a business When you’re considering entering the world of business ownership, you’ll likely encounter two main paths: buying an existing business or investing in a franchise. While both options come with their own sets of advantages and challenges, understanding the key differences can help you make an informed decision that aligns with your goals, lifestyle, and skill set. Franchising Pros: Structured Support: Franchises often provide extensive training programs, marketing support, and operational guidance. Brand Recognition: You’re buying into an established brand that customers already know and trust. Lower Risk: With a proven business model, franchises often present less risk compared to starting a business from scratch. Cons: Limited Control: Franchisors set the rules, and you’ll need to follow their operational guidelines, which may limit your creative freedom. Ongoing Fees: Franchises often require ongoing royalty fees, which can eat into your profits. Initial Franchise Fees: Besides the cost of buying the franchise, you’ll often have to pay an initial franchise fee, which can be quite hefty. Buying an existing business Pros: Immediate cash flow: When you buy an existing business, you get immediate cash flow.  Complete Control: You have the freedom to run the business as you see fit, allowing you to implement your vision and strategies. No Royalty Fees: Unlike franchises, you keep all the profits, as there are no ongoing fees payable to a franchisor. Established Operations: An existing business likely has employees, suppliers, and systems in place, saving you the time and effort needed to build these from scratch. Cons: High upfront costs: Buying a business requires a significant financial investment upfront. Make sure you’re prepared for this. Hidden issues: Every business has its challenges. Whether it’s employee issues or inaccurate financial statements, you’ll want to know about these before you buy. Time-Consuming: Taking over an existing business can be a long process, requiring extensive due diligence and potentially complicated financing arrangements. Key Considerations Whether you’re considering buying a stand alone business or franchise, it’s beneficial to think about some practical aspects first, such as: Your Skill Set: Assess your own skills and experiences. If you’re new to business ownership, the support from a franchisor might be invaluable. Financial Commitment: Both options require a significant financial investment, but the nature of the costs and on-going financial commitments differs. Risk Tolerance: Are you comfortable taking risks and solving unexpected problems, or do you find security in a proven model? Long-Term Goals: Consider your long-term business goals. Do you aspire to own multiple locations, or are you content with operating a single unit? Reasons Behind The Sale Of The Business Before you make any decisions, it’s crucial to understand why the business you’re interested in is on the market in the first place.  There are many reasons for selling a business. Be wary of owners who are just trying to offload a sinking ship. An owner that does not have a good reason to sell is also more likely to back out of the deal.  To prevent lost time and money you want a seller that is as committed to the sale as you are and has a valid reason for selling. Here are some common high motivation reasons to look out for: Retirement Health problems Divorce Disagreements between partners Death of the owner Questions To Ask The Current Owner A good idea is to spend some time with the current owner and get to know them, how they operate, how they interact with key stakeholders and what they think about the business. You can pick up a few insights into their success by spending time with them in their business. Ask them questions about the history of the business, current operations and future growth potential. Understand key relationships, potential problems and what skills they believe the new owner needs to have. 9 Steps: How To Buy A Business Step 1: Self-Assessment Before you even start looking, you need to ask yourself some questions. What are your skills? What are your goals? Do you have access to financing? What types of businesses could you effectively manage? Doing a self assessment will help you identify the type of business that’s right for you. Step 2: Market Research Once you have an idea of what you’re looking for, start researching the market. You will need to check out the competition in that market, take a closer look at customer behavior and what the industry trends are. Step 3: How To Find A Business To Buy There are various ways to find a business to buy. You can use business brokers, online marketplaces, or tap into your network. Directly from the Owner: One way to find a business to buy is directly from the owner. This often allows for more straightforward negotiations. Business Brokers: Business brokers can help you find businesses that match your criteria and budget. They can also assist in negotiations. Online Platforms: Websites like BizBuySell offer listings of businesses for sale, sorted by industry, location, and price. Networking: Your professional network can be a goldmine for finding businesses for sale. Don’t underestimate the power of word-of-mouth. Step 5: Due Diligence This is where you dig deep. Examine the business’s financial records, contracts, and any other relevant documents. You can use our Due Diligence Checklist For Buying a Business to make sure you don’t miss anything. It is important to get this step right. You don’t want to acquire a business that later turns out to be a dead weight.  Here’s a glimpse of what our Due Diligence Checklist

Introduction Acquiring a business offers the potential for significant gains, benefiting not only you but your family as well. However, there is also a substantial amount of risk that acquisition entrepreneurs are taking on. If you’re buying a business with a personally guaranteed loan, failure could decimate your financial future. That is why performing sufficient due diligence is so important.    One of the most important aspects of the due diligence process is financial due diligence. In this article, I will provide a comprehensive overview of the essential aspects surrounding financial due diligence within the context of a potential small to medium-sized business (SMB) acquisition. What financial due diligence is not. When people first learn about financial due diligence it is very common that they confuse the process for something else.  Here are a few of the common misconceptions people have: Financial due diligence is not an audit An audit is a very specific type of engagement that seeks to give an opinion on whether or not financial statements adhere to accepted accounting principles (usually GAAP in the United States). In contrast, financial due diligence aims to identify and explain trends, while also presenting a normalized view of metrics like earnings before interest, taxes, depreciation, and amortization (EBITDA), seller discretionary earnings (SDE), and net working capital (NWC). So while a financial due diligence provider may utilize the work of audit financials (if available) during their engagement, the two processes are very different. Financial due diligence is not a projection/forecast Financial due diligence is based on historical performance. The analysis of the historical period can be useful when determining the feasibility of a projection or when creating a projection.  That being said, generally an engagement to project future results will be done separately. Financial due diligence is not a valuation or a recommendation to buy or pass on the deal A valuation team may use the work from a financial due diligence provider in order to properly value a business. However, a business valuation generally requires a skillset that is different from the skillset of a financial due diligence provider. Furthermore, the decision to proceed with or decline the deal rests ultimately with you, the buyer. Your financial due diligence provider will present you with relevant facts that can help you to make an informed decision but they generally will not take a hard stance in either direction.   What are the objectives of financial due diligence? When financial due diligence is complete, the end result is typically a report that can be shared with the buyer, their lender and their investors.  When completed effectively, this report should offer insights into three key areas: 1. Understanding of the business model It is important to know how the business you are buying is generating revenue and profit. A good financial due diligence report will clearly show how a company has done that historically. 2. Normalized financials Especially when taking out debt, it is very important to have a normalized picture of the businesses financials.  For most small to mid-sized business acquisitions, the financial metrics that should be of primary concern are: EBITDA, SDE, and NWC. In order to get a proper picture of these 3 metrics a good provider will utilize a combination of the seller’s business tax returns, bank statements, and internal bookkeeping records to verify that the information that has been presented to you by the seller and their broker is factual.  3. The feasibility of your forecast While a financial due diligence engagement does not generate projections itself, it does provide you with a series of facts and figures that can help you assess the reasonableness of the projections you have created. Overview of the financial due diligence process Every financial due diligence engagement follows a different trajectory. However, generally they will move through 3 overarching stages. 1. Financial Due Diligence Preparation: Scope the Project By properly scoping the project you can greatly decrease due diligence costs, save time, and reduce potential dead deal costs.  You do this by carefully outlining the size/complexity of the business, the needs of the lender, your needs as a buyer, and the amount and quality of information that will be available from the seller.  Industry Research Even if you are already an expert in the industry it is always a good thing to do additional research. Even just spending an hour Googling the target company and skimming a few annual reports from the largest companies in the industry. Information Gathering This is where you will curate a list of items to request from the seller. Typically, the historical period that is analyzed will be 2-3 years.  At a minimum you’ll want to ask for tax returns, bank statements, and monthly internal accounting records for the historical period.  Format Information/Initial analysis As you look at companies to purchase in the range of $1-$5MM in enterprise value, what you will find is that the information will be provided in a variety of different formats in most cases.  During this step you’ll want to review every document that has been sent to you and distill all relevant information into a usable format. Oftentimes this comes in the form of an Excel file.  Once the data is in a usable format you can start to analyze it. I recommend starting to analyze the data at the highest level. Then as you notice trends and abnormalities you can drill in and build a list of questions for the seller.  A few examples of analysis that can be performed are: Year over year EBITDA bridge Tax to book bridge  Current year outturn  Seasonality analysis  Revenue concentration  Gross margin trends  Churn Analysis Fixed vs variable cost sensitivity  Employee cost analysis  Operating expense trends 2. Analysis Q&A with Seller After doing the high level of analysis it is natural to have built up a list of questions for the seller. I recommend sending a list of those questions to the seller and setting up a meeting for a few days