As far back as my first college campus visit as an energetic (and ready-to-leave-home) high school senior, I can recall the rivalry. Its emphasis only increased as I contemplated and assessed the many business-related majors offered and my long-term career aspirations. Student business groups were in on it; academic faculty were certainly in on it. By “it,” I am referring to the spirited debate between my finance and accounting cohorts as to the appropriate lens to analyze a business: cash versus accrual basis.

With all due respect to the accounting profession (which I proudly represent), the saying “cash is king” is often core gospel in the world of mergers and acquisitions. In an industry driven in many instances by valuation multiples, historical and projected EBITDA generally serve as appropriate proxys in assessing an entity’s ability to generate future cash flow. Like any good model, an output is only as good as its inputs, and trailing twelve months EBITDA as reported often misrepresents the true cash flow-generating prospects of an organization. Here are three aspects of earnings quality that are frequently overlooked by management teams in evaluating a business for sale or divestiture:

  • Pro-Forma Adjustments – In evaluating the implications of reported earnings on cash flow, certain non-cash adjustments are easy to identify (think depreciation, amortization and impairment charge add-backs). What is easy to overlook, however, are the other types of one-time events or items that are otherwise nonrecurring to a potential buyer. Examples include certain related party transactions, owner compensation arrangements, settlements and similar items. Equally important is the identification of costs, such as information technology investments, insurance costs, or similar expenditures, that may be redundant or otherwise nonrecurring to a potential buyer.
  • Normalization Adjustments – Have a significant new customer or contract during the year? If so, chances are that the associated activity did not commence on January 1 or the first day of the fiscal year. As such, adjustments to reflect the full twelve-month impact of significant business events are often necessary to more accurately project future cash flow-generating ability. Other common examples include the effects of new pricing arrangements, discontinued operations, modified or otherwise altered procurement contracts, loss contracts and open employee positions, among others.
  • Fixed versus Variable Costs – Rarely does sales activity remain unchanged year-over-year. As business volumes increase or decrease over time, it is important for sellers to articulate the implications on margins to target purchasers. An accurate segregation of costs into fixed and variable components can help a business owner tell his story and the impact of growth initiatives on future cash flow.

It is important to remember that historical EBITDA is not the end-all-be-all with respect to divestiture planning and negotiation. Forward looking projections are equally, if not more so, important to the divestiture process. Without a solid understanding of where an organization has been, however, the less likely one can appropriately message the value prospects going forward.

Thinking of selling your business or a component therein? GBQ’s full suite of capabilities can help maximize value and facilitate an effective process. Our offerings are designed to assist from beginning to end and include succession planning, business valuation, and transaction advisory, including quality of earnings (QE) and sell-side diligence reporting.

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