Three Basic Factors of Earnings

Two businesses for sale could report the same numeric value for “earnings” and yet be far from equal. Three factors of earnings are listed below that tell more about the earnings than just the number.

1. Quality of earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. Beware of the business appraiser that restructures the earnings without “any” allowances for extraordinary items.

2. Sustainability of earnings after the acquisition
The key question a buyer often considers is whether he or she is acquiring a company at the apex of its business cycle or if the earnings will continue to grow at the previous rate.

3. Verification of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectable receivables? Is the seller above-board, or are there skeletons in the closet?

Three Basic Factors of Earnings

Two businesses for sale could report the same numeric value for “earnings” and yet be far from equal. Three factors of earnings are listed below that tell more about the earnings than just the number.

1. Quality of earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. Beware of the business appraiser that restructures the earnings without “any” allowances for extraordinary items.

2. Sustainability of earnings after the acquisition
The key question a buyer often considers is whether he or she is acquiring a company at the apex of its business cycle or if the earnings will continue to grow at the previous rate.

3. Verification of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectable receivables? Is the seller above-board, or are there skeletons in the closet?

A Listing Agreement is More than Just a Piece of Paper

In order to sell one’s business using the services of a business broker, a listing agreement is almost always required.

For the owner of the business, signing the agreement legally authorizes the sale of the business. This simple act of signing represents the end of ownership. For some business owners, it means heading into uncharted territory after the business is sold. For many it also signifies the end of a dream. The business owner may have started the business from scratch and/or taken it to the next level. A little of the business owner may always be in that business. The business, in many cases, has been like a part of the family.

For buyers, the signed listing agreement is the beginning of a dream, an opportunity for independence and the start of business ownership. The buyer looks at the business as the next phase in his or her life. Pride of ownership builds.

So, that simple piece of paper – the listing agreement – is the bridge for both the seller and the buyer. The business broker looks at that piece of paper through the eyes of both the buyer and the seller, working to help both parties progress through the business transaction process into the new phase of their lives.

What a Buyer May Really Be Looking At

Buyers, as part of their due diligence, usually employ accountants to check the numbers and attorneys to both look at legal issues and draft or review documents. Buyers may also bring in other professionals to look at the business’ operations. The prudent buyer is also looking behind the scenes to make sure there are not any “skeletons in the closet.” It makes sense for a seller to be just as prudent. Knowing what the prudent buyer may be checking can be a big help. A business intermediary professional is a good person to help a seller look at these issues. They are very familiar with what buyers are looking for when considering a company to purchase.

Here are some examples of things that a prudent buyer will be checking:

Finance

  • Is the business taking all of the trade discounts available or is it late in paying its bills? This could indicate poor cash management policies.
  • Checking the gross margins for the past several years might indicate a lack of control, price erosion or several other deficiencies.
  • Has the business used all of its bank credit lines? Does the bank or any creditor have the company on any kind of credit watch?
  • Does the company have monthly financial statements? Are the annual financials prepared on a timely basis?

Management

  • Is the owner constantly interrupted by telephone calls or demands that require immediate attention? This may indicate a business in crisis.
  • Has the business experienced a lot of management turnover over the past few years?
  • If there are any employees working in the business, do they take pride in what they do and in the business itself?

Manufacturing

  • What is the inventory turnover? Does the company have too many suppliers?
  • Is the business in a stagnant or dying market, and can it shift gears rapidly to make changes or enter new markets?

Marketing

  • Is the business introducing new products or services?
  • Is the business experiencing loss of market share, especially compared to the competition? Price increases may increase dollar sales, but the real measure is unit sales.

When business owners consider selling, it will pay big dividends for them to consider the areas listed above and make whatever changes are appropriate to deal with them. It makes good business sense to not only review them, but also to resolve as many of the issues outlined above as possible.