Quality of Earnings

When Performing a Business Valuation

Earnings are not always objective and valuations apply a multiple to earnings to determine a company’s value. The elements making up a company’s valuation involve determining normalized earnings, a decision whether income taxes would be applied, and the capitalization rate to be used to get the value. There are also other factors, but this article looks at the quality of earnings.

It is always about the earnings—except when it isn’t.  There are some situations where a company could be acquired based upon strategic, synergistic, or ego considerations, but otherwise, valuation all boils down to a dependence on earnings and the quality of such earnings.

Earnings are not always objective and valuations apply a multiple to earnings to determine a company’s value.  The elements making up a company’s valuation involve determining normalized earnings, a decision whether income taxes would be applied, and the capitalization rate to be used to get the value.  There are also other factors, but this article looks at the quality of earnings.

Cash flow

In most sales, what the buyer is acquiring is the predictability of cash flow.  Cash flow is an element of earnings, but contains other issues such as: noncash receipts or expenditures entered on the financial statements, changes in working capital, and other balance sheet components.  Reported earnings are the starting point and at some point, they need to be converted into operating cash flow.  The normalization of earnings process adjusts for this.  There are many ways to discuss cash flow and there have been many buzz words describing it, but as they said in the movie, “show me the money!”

Usually when an earnings calculation is done, no consideration is given to changes to working capital components such as increases in accounts receivable or inventory.  However, it would be appropriate to review these items and in particular, changes in the borrowing and fixed asset acquisition structure when determining the quality of earnings.

As will be seen in this article, the normalization process would also include consideration of items that do not affect the profit or loss, but do affect the cash flow.  I believe a careful analysis of earnings and the dynamics of a company’s operations will result in a bottom line normalized earnings that would also coincide with the company’s cash flow; so in a larger sense for most situations, these amounts become synonymous.

EBITDA

EBITDA is a commonly used acronym for a representation of profits.  The letters stand for Earnings Before Interest, Taxes, Depreciation, and Amortization.  EBITDA is supposed to indicate the maximum amount of cash flow from a business’ operations that is available to be reinvested in the business, service debt by paying interest and repaying principal, and provide a return on investment to the owners.  One important issue not considered in determining EBITDA is the recurring need of the business to add to its fixed assets or equipment.  For this reason alone, I reject the use of EBITDA as it is currently (and widely used by many) and it will not be further discussed here.

Capitalization of earnings rate

Capitalization of the earnings is a general way of determining the value of a business by converting anticipated benefits into a current value.  In this method, a representative earnings amount is divided by a capitalization factor to arrive at the company’s estimated value.

The capitalization rate considers such factors as the level of interest rates, rates of return expected by investors on relevant investments, the risk characteristics of the anticipated benefits and the quality of the earnings, and predictability of its continuance.  A use of earnings approach is appropriate for profitable companies where the assets used by the business are integral to the business without comparable or significant value apart from the business.  Replacement cost, original cost, depreciated cost, liquidated or knock down value, or any other form of value of a business’ assets bear no relevance if they do not produce an income stream.  In valuations, estimates also have to be made of the additional working capital that might be needed concurrent with, or very closely after, the closing.

The capitalization rate is an important element in a business’ valuation but will not be discussed further as our concern is the quality of earnings.

Earnings

Potential future income is a major factor in many valuations of closely-held interests, and all information concerning past income which will be helpful in charting or predicting the future should be secured.  Prior earnings records are reliable guides as to the future expectancy.

Determining earnings and its quality is an important beginning step.  The earnings are the bottom line on the company’s statement of operations—the net income.  In addition to the reported earnings, it is usual and necessary to adjust that amount to normalize the earnings for optional, discretionary ownership payments, nonrecurring items and asset and liability adjustments that would affect operating results to determine the regular operating income, and cash flow from operations.  Once the normalized income is determined, further adjustments might be in order to arrive at the business’ cash flow.

Note that there are many ways earnings are determined, such as: for tax purposes, GAAP, EBITDA, regulatory, or internal use purposes.  Regardless of the method and starting point, adjustments usually need to be made to determine the normalized earnings a potential buyer would start their analysis from.

I’ve identified four categories of items that would be adjusted for, illustrated below:

(1) Optional payments

So called optional, excessive, or unnecessary payments that would be added back to the net income include the following:

• Owners’ salaries in excess of what would be paid to non-owners performing the same functions
• Owners’ family members receiving payroll or consulting fees also in excess of what would be typically paid for such services
• Excess fringe benefits for owners and their families
• Insurance premiums for personal or excessive coverage compared to what is being offered to employees
• Life, disability, and long term care insurance premium payments
• Health care expenses for owners
• Expenses for vehicles not used primarily in the business
• Travel, entertaining, sports, and ticket expenses not for direct or actual business purposes
• Rent paid for owner owned property in excess of market rent, as adjusted for rent collected from unrelated parties
• Repairs, maintenance, utilities, supplies, and any other payments that can be attributed to the personal use of or benefit to the owners
• Temporary occupancy costs or rent for primarily personal use
• Contributions made to the owners’ favorite and personal charities; such as their church
• Any other items not necessary for operating the business where the benefit inures to the owners

Note that most businesses will not have every one of these, and there are others that are not included here.  The object is to review all the expenses to determine what would not be continued with a new owner, and then eliminate them to arrive at a normalized net income.

(2) Nonrecurring costs

Another group that would need adjusting is one time or nonrecurring costs or expenses that would not be duplicated in later periods or under different ownership.  Some of these are as follows:

• Bonuses or incentive payments to employees for specific extraordinary performance
• Consulting fees for special onetime projects
• Higher than market salaries for certain key and unrelated people performing services that are beyond the scope of their usual responsibilities and that an owner/officer usually would be expected to do
• One time supply chain replenishment costs
• Reduction of gross profit from added revenues from customers that previously cut back and now restocked their inventory to bring it to more regular or prior levels
• Adjustment for gross profits or losses included from sales from one time clean out of old or obsolete inventory that was sold
• Product recall costs
• Water or storm damage repairs
• Moving costs
• Gains or losses resulting from the sale or abandonment of fixed assets
• Write off of a product line or a business development project
• Buy-out of a long-term contract
• Damage receipts from accidents or disasters

(3) Costs not chargeable to operations

Another group is actual and regular costs that do not belong in the calculation of “normalized” earnings such as:

• Interest payments
• Interest income
• Expenses not representing cash expenditures such as depreciation and amortization
• Income not representing cash infusions such as accrued contingent revenue expected to be received in later periods
• Income taxes

(4) Asset valuation adjustments

A further category that should be looked at is one that requires adjustments to asset values that would affect the earnings such as:

• Accounts receivable adjustments for uncollectible accounts
• Reserves for sales returns, allowances, warranties, customer complaints, advertising credits, and similar items based on representations to customers
• Excessive upfront contractual payments for periods extending over successive years
• Annual payment items for periods stretching into the following year
• Equipment or fixed asset purchases, additions, renovations, or major maintenance projects that should be capitalized rather than expensed

Income taxes

Further adjustments need to be considered for corporate income taxes to have the company’s earnings conform to conventional businesses.  This has become a complicated area about whether adjustments are in order.  I contend they should be made to the normalized profit to have the business’ net income reflect what would be available to owners after taxes.  If the business operated as a C corporation, there would be no choice since corporate taxes would be payable on the income.  However, if the entity was to be a nontax payer such as a partnership, LLC or S corporation, the owners would pay the tax on earnings attributed to them.  Issues arise as to what the appropriate tax rate would be (which I would leave for another article) other than to suggest some rate be used to approximate a blended tax rate that would be representative of the taxes that would be charged against the earnings; recognizing a portion of that tax should not be charged to the operations to the extent there are distributions that are not intended to be reinvested in the business.

Capital structure

While capital activity does not factor into a determination of earnings, there should be a review of the capital structure, need for regular or permanent borrowing, and continuous fixed asset acquisition.  An awareness or recognition of this would affect the valuation and, to some extent, might need to be factored into the earnings either by including interest costs, loan principal repayments, or regular and periodic capital expenditures.

It is also a fact of life for a growing business that there is a thirst for added cash to fund accounts receivable growth and inventory build-up and long-term financing of additional fixed assets.  While not part of an earnings calculation, these issues cannot be disregarded.

Sustainability of earnings

The sustainability of earnings world need to be considered based upon the company’s history and current and projected operations; whether there have been any changes in operations, major customers or types of customers, location, loss of essential employees, and outside elements that would affect the continuance of the company’s trends.  Trends such as economic or industry factors, commodity prices and availability, and susceptibility to disruptive activities; the continuance of marketplace strength of the company, brand or product, and ease or difficulty of a competitor entering the market.

Usually an analysis includes a five-year backward look at historical earnings and a forward glimpse using the company’s budgets and projections.  Trend analyses and data mining are also important tools to detect latent changes not already considered.

Any determination of earnings involves many judgments and results in a single amount.  Each of the many steps in determining that amount has to be done carefully and deliberately with a focus on the multiplier effect on the final conclusion.  A trained appraiser will consider and fully document the adjustments they use so that the user of the appraisal can apply and add their judgment and knowledge to the process.  Because at the end of the day, there is a purpose of the valuation and decisions will be made based upon it.

Conclusion

The quality of earnings is the starting point to determining the value of many businesses.  Valuing a business or providing for the future involves judgments about the continuance of the present mode of operations, anticipated changes and growth, future conditions, and projections of liquidity and cash needs.  It is, at its best, an opinion at that moment of time and because of that, needs to be considered on the side of caution.  So, use earnings when you start, but don’t confuse it with the ending point.

Edward Mendlowitz, CPA, ABV, CFF, is partner with WithumSmith+Brown, PC, in New Brunswick, New Jersey. Mr. Mendlowitz is one of Accounting Today’s Most Influential People. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York. He writes a twice a week blog at www.partners-network.com.
Mr. Mendlowitz can be contacted at: (732) 964-9329 or by e-mail at: emendlowitz@withum.com