The Most Important Agenda Item Missing from Your Monthly Finance Management Meeting
Walter Adamson
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As the economy tightens, buyers are becoming increasingly sophisticated in evaluating potential acquisitions, focusing more on assessing the quality of a company's future earnings rather than relying on historical financial statements.
Typically buyers would closely examine past financial performance in detail, with particular attention given to the add-backs in the Normalised EBITDA and noncash items such as deferred revenue, inventory levels, and the overall health of the balance sheet, especially concerning debt levels and working capital management.
In addition to increased scrutiny of future earnings, buyers are now paying more attention to intangible assets such as customer relationships, brand recognition, and intellectual property. This increased attention is to help them better understand how much value they can extract regarding EBITDA growth post-transaction relative to the respective risks.
Buyers now focusing more on quality of future earnings
The shift to focus more on future earnings is driven by the need for buyers to understand more of the true value of a business before committing to an offer price. Or, to restate this more accurately, it is driven by a greater need to assess the materiality of the risks to future earnings.
A buyer may find the risks acceptable - within a tolerable range - or unacceptable and walk from the deal, or risks the buyer can mitigate or migrate. In the latter case, the buyer will highlight the risks as justification to lower their valuation while knowing that they are unlikely to have suffered any loss of value on their higher offer.
How are owners contemplating a sale within the next 2 years responding to this shift?
While assessing the quality of earnings has always been a fundamental part of a valuation process, it is rarely on the monthly agenda for middle-market companies. Yet by regularly assessing the quality of earnings, owners can better understand their company's underlying performance and its potential for future growth, profitability and enterprise value.
If you are not reviewing the quality of earnings monthly, then you, as an owner, will inevitably leave money on the table for a buyer.
In fact, results show that improved quality of earnings results in not only higher profitability but also a higher multiple when selling - benefiting owners twice.?
What is exactly is Quality of Earnings and how to improve it
"Quality of earnings" refers to the degree to which a company's earnings are reliable, sustainable, and likely to continue. Therefore, improving the quality of earnings is crucial to increase your company's value to potential acquirers.
Conversely, a business with low-quality earnings, i.e. volatile or unpredictable earnings that are subject to fluctuations in the market, customer behaviour, etc., is considered riskier and less valuable to potential acquirers.
You can take several steps to improve the quality of earnings. One of the most important is to develop a recurring revenue model. This revenue is more stable and predictable as long as customers have a low churn rate.
Hence, another step is to focus on reducing customer churn. For example, you can reduce churn by providing good customer service and also by providing additional value to customers over time. On the other hand, a high churn rate leads to death by a thousand cuts because the cost of customer acquisition mostly exceeds the accumulated marginal profit from the fleeing customers.
Additionally, you can also improve the quality of earnings by diversifying your customer base. Diversification helps create a more stable and sustainable revenue stream.
Bear in mind that diversifying does not necessarily mean having to service more customers at any one time (requiring substantial new investment or working capital). Instead, it can mean having a more extensive pipeline of customers who trust you and buy from you on a semi-regular or period basis, according to their investment cycles.
Returning to basics, focusing on improving cost management can also improve the quality of earnings, primarily by reducing the impact of fixed costs on the business.
The case of a manufacturing company is an excellent example of how improving the quality of earnings can result in a significant increase in the value of the business. This company had a recurring problem with excess inventory, tying up capital and leading to substantial write-downs.
As a result, the company reduced inventory levels by improving its inventory management systems, leading to a significant increase in cash flow. This action, in turn, resulted in an increase in EBITDA from $5 million to $7 million and a corresponding increase in the sale price of the business from 5x EBITDA to 6x EBITDA.
A study conducted by McKinsey found that companies with solid earnings quality received a 28% higher price multiple in M&A transactions compared to those with poorer earnings quality.
Takeaway - QoE planning puts money in your pocket
By reducing risk and increasing the predictability and sustainability of earnings, your businesses became more attractive to potential buyers, resulting in higher valuations and more money in your pocket.
It takes time to get there; typically, you need to start 18 to 24 months before the date you are anticipating a sale transaction.
Whether you are considering selling your business or not, the best way to start is to add a "Quality of Earnings" review to your monthly management agenda. Running this review regularly also brings your attention back to focusing on the business and not being in the business.
Case studies demonstrate the effectiveness of improving the quality of earnings in increasing the value of a business to potential acquirers.
FAQs - Improving Quality of Earnings and Impact on Sale Price
Q: How can I improve the quality of earnings?
A: There are several steps you can take to improve the quality of earnings, including:
Q: How much impact does improving the quality of earnings have on the sale price of a business?
A: Improving the quality of earnings can significantly impact a business's sale price, with studies showing a potential increase of up to 28% in price multiple for companies with solid earnings quality.
Think of it this way: (illustrative only) let's say the average price multiple in your industry is 5.5 and firms typically have a mixture of consulting, project and recurring revenue. A firm with revenue heavily weighted towards consulting might attract a multiple of 4.5; one with a high proportion recurring revenue achieve 6.5.
Q: How long does it take to improve the quality of earnings?
A: Improving the quality of earnings is an ongoing process that may take several months or even years to implement fully. It requires a commitment to improving financial reporting and internal controls and a willingness to invest in technology and in educating customers of the value your recurring revenue offers. Be prepared for cashflow and revenue to drop during a transition to high levels of subscription revenue. You can typically expect to see a difference within 12-24 months of implementing measures to improve your quality of earnings.
Conclusion
Improving the quality of earnings is a critical factor in increasing the value of your business to potential acquirers. By reducing risk and increasing the predictability and sustainability of future earnings, your businesses becomes more attractive to buyers, resulting in higher valuations.?
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This Week's Reading
Two articles from my reading list to help you grow and exit successfully.
Article 1: How B2B digital leaders drive five times more revenue growth than their peers
In analysing B2B companies leading in digital transformation, McKinsey found that commitment to digital at a strategic level is a differentiating factor.
At the strategic level, companies that are committed to digital outperform those that are not.
Unfortunately, many B2B companies fail at this, allowing their digital strategies to become a sideshow instead of a priority. This leads to initiatives often disconnected from customer needs, which can cause them to lack investment and focus.
Only 10 per cent of surveyed B2B companies reported that digital was a top priority for investment, leading to outcomes where their average Digital Quotient (DQ) was 44 compared with 50 of consumer companies.
When held off as an afterthought, many digital strategies splinter into small initiatives that lack long-term momentum or impact. Without purpose behind these acts, top-quartile B2Bs suffer greatly compared to their sector peers.
What is needed, say Mckinsey, is a strategic commitment that results in digital strategies designed to shape and make markets, coupled with the resources to back it up.
Source: McKinsey
Article 2: The Importance of Sellers Conducting a Quality of Earnings Review
In this podcast interview, a Director at Cohen & Company, Andrew Jordan, explains why he believes sellers should commission an independent Quality of Earnings (QoE) review.
In particular, when asked, "What do you think the buyer's perception would be seeing a seller that has a prepared QoE versus seeing a seller without one?" he gave an interesting answer.
Namely, a buyer's perception of a seller with a prepared QoE versus one without can be different, i.e. more favourable.
A QoE provides an objective view of the business, giving buyers clarity and assurance that their due diligence has been thorough and complete. It also ensures that the information is reliable, accurate, and unbiased.
A prepared QoE report may help sellers negotiate better terms in M&A valuations. With the objective benchmark provided by the report, buyers are likely to feel more confident in their decision and may be more willing to offer a higher price. A seller with a QoE report can also show potential buyers that they are organised and clearly understand their financials.
On the other hand, seeing a seller without a QoE report may give buyers pause for concern. Without an objective benchmark to measure metrics, buyers may struggle to decide whether or not to invest. In addition, variations in data interpretation may lead to heightened levels of scepticism when negotiating.
Source: dealroom.net
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This Week's 3 Business Books
Free for you as a subscriber to my newsletter: Three of the world's most essential and popular business books in acclaimed 12-minute videos. Listen, or watch and listen to take advantage of another big idea.
Book 1: Good Strategy Bad Strategy, by Richard Rumelt (Watch or listen on Monday - Tuesday)
You're the head honcho, the big brain. Now that you've got 'strategy' in your job description, it's time to figure out what's good, bad, and what to leave for your retirement novel.
Book 2: Managing (Right) For The First Time, by David Baker (Watch or listen on Wednesday - Thursday)
Woken up and found yourself as a leader or in middle management? Chances are you need to prepare yourself for this role. Luckily David Baker has some great advice to help you make it through the rest of the day doing more good than damage.
Book 3: Read this Before our Next Meeting, by Al Pittampalli (Watch or listen on Friday - Sunday)
Meetings suck. They can drain energy, money and passion from any company. But there is hope. Watch this summary to put a new form of engagement on your agenda. It will transform your workplace.
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Keep winning, Walter
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