In particular, the quality of earnings analysis looks at a company’s EBITDA and working capital. Are they incidental or structural? What are the main cash flow generating components of the business? What does that cash flow look like going forward? A company may have a positive net income but a large negative cash flow. This may mean that the business is not in as good shape as it appears at first glance. We have developed a structured approach and methodology to produce a quality of earnings report.
An example of a quality of earnings analysis in a portfolio company acquisition was the addition of a manufacturing group that was increasingly becoming a challenger in a market with overcapacity. This was a founder-owned business with three sites in different countries. It was a well-organised and therefore short-term process. The standard components used to normalise EBITDA and working capital are:
- non-recurring income and
- expenses and differences due to accounting policies.
A new insight also came from the composition of the margin. In this type of business, part of the production is sometimes sold to a business partner and bought back after processing, or it is produced under a toll-manufacturing agreement. In both cases the gross margin is very different from the other business.
In our experience, it is common for portfolio companies to continue to break out non-recurring income and expenses in management reporting even after the purchase of add-ons. The advantage of this is that at the time of sale, the PE company can make it clear to the buyer what recurring results can be expected. This also saves valuable time in the sale process. In addition, a buyer and the buyer’s auditor will appreciate that a thorough quality of earnings report has been provided by an independent third party who can explain, as part of the negotiation process, how the normalised figures have been arrived at.
The preparation of a quality of earnings report is often a labour-intensive exercise. Therefore, such an assignment is usually carried out by several CM&P partners.