Three Basic Factors of Earnings
When evaluating businesses for sale, it’s crucial to look beyond the raw earnings numbers and consider several key factors that provide deeper insight into the company’s financial health and future prospects. Here are three critical aspects to examine:
1. Quality of Earnings
The quality of earnings measures how accurately the reported earnings reflect the true operational performance of the business. High-quality earnings come primarily from core business operations, while low-quality earnings may be inflated by one-time events or accounting maneuvers. At Indiana Equity Brokers, we carefully analyze earnings quality by scrutinizing:
- “Add backs” and non-recurring items
- One-time events like property sales
- Extraordinary expenses and their frequency
- Allowances for typical annual extraordinary costs
Beware of valuations that completely eliminate all extraordinary items, as some level of unexpected expenses is normal for most businesses.
2. Sustainability of Earnings Post-Acquisition
Buyers must consider whether the reported earnings represent a peak in the business cycle or if they can be sustained and grown after the acquisition. Key questions to ask include:
- Is the company at the top of its growth curve?
- Can the previous growth rate be maintained?
- Are there untapped opportunities for expansion?
Our team at Indiana Equity Brokers can help you assess the future earnings potential of a business and identify growth opportunities.
3. Verification of Information
The accuracy and reliability of the financial information provided is paramount. Buyers should verify:
- Timeliness and accuracy of financial reports
- Allowances for potential product returns
- Provisions for uncollectible receivables
- Overall integrity of the seller and potential undisclosed issues
A thorough due diligence process is essential to uncover any “skeletons in the closet” and ensure you have a complete and accurate picture of the business’s financial situation. By carefully examining these three factors – quality of earnings, sustainability, and information verification – buyers can gain a much clearer understanding of a business’s true value and potential. This deeper analysis goes far beyond simple earnings numbers and is crucial for making informed acquisition decisions.
