When considering the acquisition of a restaurant or a restaurant group, it is important to engage Transaction Advisory Services (TAS) professionals to perform financial and tax due diligence. Financial due diligence centers on the Quality of Earnings (QofE) analysis, which assesses the sustainability and accuracy of the restaurant’s reported core financial performance. Financial and tax due diligence is crucial for potential acquirers, as it helps determine the true quality and consistency of the restaurant’s earnings.
The QofE is derived from the past two or three years of detailed historical financial information of the restaurants to be acquired, with most emphasis placed on the trailing 12-month period. The purpose of a QofE is to measure a restaurant’s ability (on a quantitative and qualitative basis) to be profitable at its core business by challenging and analyzing historical financial activity.
There are many measures of profitability or earnings, with the most common quantitative measure being Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The qualitative aspects of due diligence focus on the upside opportunities and downside risk factors associated with the revenues and expenses that drive earnings.
Get to GAAP
- Small businesses frequently utilize the cash basis or tax basis of accounting. Bankers and investors require financial statements to be reported in accordance with U.S. Generally Accepted Accounting Principles (GAAP) or the accrual basis of accounting. The seller’s financial information must first be converted to GAAP, which will result in increases or decreases in revenues and expenses and corresponding changes in assets and liabilities.
Normalize Revenues and Expenses
- Revenue or income that is non-core or non-recurring, such as PPP loan forgiveness, Employee Retention Credits (ERC), bank debt forgiveness, gain on sale of equipment, litigation awards, insurance claim awards, and workers’ compensation refunds.
- Expenses or costs that are non-core or non-recurring, such as family members on the payroll that perform limited or no duties, owner personal expenses run through the business, owner compensation over replacement compensation, litigation fees and on losses, loss on sale of equipment, loss on closed restaurants, new restaurant preopening costs, inventory write-offs.
- Run rate adjustments to reflect newly opened, remodeled, or closed restaurants to best reflect a fully operational restaurant over the historical time period being analyzed. Also, consider trending increases in kitchen and server payroll due to sustained inflationary pressures on payroll and benefit costs.
- Capitalize vs expense for repairs and maintenance expenditures. It is important to ensure all costs incurred to repair and maintain the facilities and equipment are capitalized or expensed in accordance with GAAP. Note that the tax accounting for repairs and maintenance expenditures may differ from GAAP. It is also important to note whether repairs and maintenance have been deferred, translating into additional costs to the buyer to get the asset in the condition necessary to continue generating business. Deferred maintenance will decrease the selling price.
- Corporate office overhead expenses may or may not be allocated to each restaurant. It is important to allocate certain of these expenses by using a logical and consistent methodology. The type of expenses to be allocated are those that would be incurred in the normal course of business at the restaurant level if the corporate office did not exist.
Analyze the Core Financial Performance
- Assess the predictability and sustainability of the recurring revenues and expenses at the core of the business through the use of restaurant industry and franchise system Key Performance Indicators (KPIs). This in-depth operational and financial data analysis will confirm important upside opportunities and downside risks.
- Customer KPIs – traffic count, average sales per customer, customer ratings and reviews, reservations, walk-ins, cancelations, no-shows, eat-in vs. carry-out, sales per available seat hour, turn time of table turnover.
- Employee KPIs – employee engagement scores, employee turnover, wages per employee, employees per shift, sales per employee per shift.
- Sales and costs KPIs (food, beverage) – sales, sales by item, cost by item, margin by item, inventory turnover, food waste, beverage shrinkage.
Low-Quality vs. High-Quality Earnings
- Determine the level of aggressiveness in historical financial information and the future financial forecasts or projections. Assess the nature and extent of aggressive or optimistic accounting and financial forecasting and quantify the potential impact on the quality of earnings. It is important to analyze all of the adjustments to revenues and expenses in the QofE to understand the timing and amount of the cash inflow or outflow impact.
Benefits of Due Diligence and QofE Analysis
- Financial information will be converted to and presented in accordance with GAAP, which can be shared with investors and lenders to secure financing. It provides an unbiased evaluation of the core financial performance, helping potential buyers and lenders make informed decisions.
- Increase the buyer’s negotiating leverage since more will be known about the strengths and weaknesses of the business. It may also identify and flag potential deal breakers. For sellers, it provides transparency to the true financial performance of the business, which is crucial when trying to reach an agreed-upon selling price.
- Roadmap of the accounting policies and internal controls that need to be improved or implemented to generate timely and accurate financial information and reporting.
- Project plan and identification of what needs to be improved operationally to increase the profitability of the core business. Focus on sustainable earnings that generate repeatable and predictable cash flows in the future.
- Net working capital adjustment components become easier to quantify and negotiate, therefore avoiding or mitigating post-acquisition disputes between buyer and seller.
Are you in the process of acquiring a restaurant or a restaurant group, and have questions related to the process? Contact Kyle McKee or Dustin Minton today.
