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Why is ‘Quality of Earnings’ Important?

Many owners have heard of EBIT, EBITDA or Adjusted Earnings, all various ways to calculate the earnings of a business. What does ‘quality of earnings’ have to do with it? Absolutely everything. 

First, let’s define ‘quality of earnings’: The proportion of income attributable to the core operating activities of a business. (In other words, earnings that are repeatable and reasonably predictable.)

However, what if a company reports solid earnings, but a poor quality of those earnings? Some examples of poor-quality earnings may help clear the fog. Our hypothetical company is ABC Restoration, a single location, full-service disaster restoration company with $7.5M in gross sales for YE 2018, with earnings calculated at $1M.null

But, what if….

  • In ’16 and ’17, their sales were $2.1M and $2.3M respectively, but in ’18 they had a single $5M project, which netted them $800K of profit. 
  • The $5M project actually occurred in Q3 and Q4 of ’17, but due to a cash-basis reporting, many of the expenses ended up in ’17, with the bulk of the income arriving in ’18.
  • In ’18 there was over $4M of sales that came from a new Vendor program. Because of non-conformity to reporting requirements, the vendor has threatened to remove ABC from the program. 
  • There happens to be 4 owners at ABC: Dad running operations, Mom managing the office, Son as a Senior PM, and Daughter as a Lead Estimator- all wanting to retire upon the sale of the business.

These are all true scenarios (with dozens more variations). As a buyer, should these circumstances give you pause? Yes. They significantly affect value. Some even dictate deal structure.   (FYI- every industry is suspect to these types of scenarios.)

Per the above, no buyer will dispute the $1M in earnings. It was real and the owner can prove it. What’s disputed is the the story behind the numbers, specifically the ‘high-risk’ portion. The disclosed earnings should reflect what a new owner could expect to receive in the short-term.

Any buyer will ask numerous questions surrounding earnings, a few included:

  • Were earnings due to normal operations of the business?
  • Were there any extenuating circumstances?
  • What’s the true story behind the numbers?
  • Can I the buyer expect to replicate those earnings?
  • W ill there be payroll adjustments for key employees and/or family members?

Buyers and investors like high-quality earnings, along with a clean story to match. Presented properly, defending a premium price becomes more realistic.