As we perform diligence/Quality of Earnings, most of our clients are focused on earnings. Based on our years of experience we have noted our clients are not typically concerned about the balance sheet (outside of working capital calculations). In this blog we will discuss the importance of understanding the balance sheet when assessing earnings.
The income statement is really a function of the balance sheet. Most stakeholders are rightfully concerned about profitability. However, if you have ever been involved in a financial statement you may notice that a significant amount of the testing is over the balance sheet. The reason for this is the income statement is derived from the balance sheet. If you do not have an accurate balance sheet you cannot have an accurate income statement. While we spend most of our time in diligence honing in on a normalized EBITDA number, a solid portion of our time is spent analyzing the balance sheet to get a level of comfort around its accuracy.
To help with the understanding of how misstatements (or even an accurate balance sheet) can affect EBITDA, we have further described a few scenarios below.
Inventory: When inventory is first purchased it is a balance sheet transaction. Amounts go to inventory (or at least they should!) with an offset to cash or accounts payable. Simply stated, when a sale is made, most of us understand relieving inventory results in recording cost of goods sold resulting in your gross margin.
If inventory is not reported correctly on your balance sheet you cannot have accurate earnings. While accounting standards require inventory to be stated at the lower of cost or market – here, in the lower middle market, that is not always the case.
For example, years ago I was working on a transaction where the Target’s product included metal. While margins looked relatively consistent the Company was reporting consistently increasing inventory levels. We performed an assessment of inventory pricing noting that the Controller was indiscriminately adjusting inventory prices on a monthly basis to improve earnings. This had the effect of overstating inventory and understating cost of goods sold inflating earnings. Our downward Quality of Earnings adjustment to report inventory at cost effectively killed the deal as it resulted in substantially lower EBITDA than the partners were trading on.
In another instance, our private equity client engaged us to assess one of their portfolio companies’ financials as the company was showing a profit but had no cash. We quickly determined the CFO was dealing with a system issue and overstating inventory and margins. The subsequent adjustment resulted in a significant loss and liquidity issue.
Fixed assets: As we all know, fixed assets such as equipment require capital and are typically purchased from a third party. We typically assess growth and re-occurring capex as part of diligence. Normally fixed assets require a one-time cash outlay or are financed. Obviously, this affects earnings.
However, you may not know that sometimes companies utilize internal resources to generate fixed assets that are reported on the balance sheet. In one case during diligence and an assessment of fixed asset additions, we determined the Target was utilizing production employees to generate tooling to be used in future production. As a result, a portion of the labor for these production employees were being capitalized on the balance sheet and not reported on the income statement until the assets were depreciated. As a result, the cost never hit EBITDA.
We concluded this was a significant Quality of Earnings adjustment. The Company was required to keep these employees on hand to meet current production levels. Putting these employees as part time production employees would substantially affect the business so was not a viable option. The resulting adjustment significantly reduced EBITDA and the overall valuation.
This is a situation where even when the Target is recognizing the accounting appropriate (as you can capitalize internal labor), understanding the balance sheet and associated trends is critical to determining adjusted EBITDA.
Deferred revenue: In its simplest definition, under US GAAP, revenue is to be recognized when realized/realizable or earned. We have encountered countless scenarios where understanding the trend in deferred revenue affects normalized adjusted EBITDA. As a result, we always strip changes in deferred revenue (and any associated capitalized costs out of EBITDA usually as a second level of adjusted EBITDA). Why do we do this? If significant deferred revenue exists, earnings can be misleading.
For example, the Target may have signed up a large one-time contract at the end of last year performing the services over 12 months. However, cash is received from the customer upfront and revenue deferred. The agreement is not renewing. If only the historical income statement is reviewed it may appear that we are paying on the appropriate EBITDA number. However, a detailed analysis of the deferred revenue account demonstrates that this contract is “falling off” and normalized EBITDA is much lower.
These are just a few examples of issues that can be identified through a balance sheet analysis. Hopefully this provides some insight into the importance of the balance sheet when assessing EBITDA. If you’d like us to look at a Target’s balance sheet (or perform full diligence) please reach out to me, Chris Fameree, firstname.lastname@example.org.
ABOUT THE AUTHOR – CHRIS FAMEREE, MANAGING PARTNER
Chris Fameree is the founding partner of Assure with nearly 15 years of combined public accounting and industry experience. He has led and participated in numerous engagements including buy side and sell side due diligence engagements, SOC 1 & SOC 2 engagements, financial statement audits and other advisory projects.
Prior to founding Assure, Chris was a Senior Manager in the Transaction Advisory Services Group and Audit Group of a large regional CPA firm. During this time, Chris participated in numerous business combinations and due diligence assignments. These transactions ranged from $10 million to over $100 million in value. Chris also worked at a national CPA firm, where he served lead roles on engagements from international Fortune 500 companies to closely held private manufacturers.
Chris received his Bachelor of Business Administration in Accounting from the University of Wisconsin. He is licensed as a Certified Public Accountant in North Carolina and Wisconsin.