Companies that are looking to be acquired have every incentive to put their best foot forward, presenting their earnings history in the most beneficial light. One of the most important functions of a due diligence engagement is to evaluate the quality of earnings of the target company to ensure that the financial information used to evaluate the prospective deal include only recurring, sustainable revenue from operations. When evaluating the quality of earnings of a target company, consider the following:
- Look for one-time, unusual, or non-operating events, both positive and negative, and adjust the financial statements to eliminate their impact. Examples include gains or losses on disposals of assets and insurance proceeds.
- Inquire about related entities and related parties, and request detail of all transactions. Income should be adjusted to the extent that these transactions do not reflect market rates.
- Be aware of the possibility that the target company may be paying expenses on behalf of a related entity (or vice versa). Such transactions must be accounted for as intercompany receivables. If they are not, quantify the amounts and timing of the transactions and adjust earnings accordingly to ensure revenue and expenses are recognized in the proper company.
- Examine management salaries and adjust to market value if needed. In privately held businesses, owners/operators may pay themselves salaries at below-market rates and make up for the difference by taking a distribution of equity. Careful consideration should be given to what a normal management salary would be for the new owners to operate the company efficiently.
- Consider costs that would not exist under new ownership, e.g., cars, cell phones, gas cards, car insurance, home office costs, and salary or other benefits to family members who do not perform work for the company.
- Rent and other property costs should be adjusted to reflect actual cost that would be incurred if the property were to be leased by the new owner at prevailing market rates.
- Other owner perks such as entertainment, travel, meals, key man insurance, and personal term or whole life insurance should be eliminated to the extent that they will not continue under new ownership.
The above list is not exhaustive, but rather highlights some of the most common earnings normalization adjustments. Schneider Downs Business Advisors are available to assist you in evaluating a prospective acquisition or preparing your own company to be sold. For more information, explore our Due Diligence and other Business Advisory Services.
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