Quality Check Your Investments

 
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Thorough investigation into the quality of earnings helps buyers decide if the price of a business is right. When it comes to buying a business, paying too much for it can have serious ramifications, affecting financing along with the future revenue of your business. That's why it's so critical to understand whether the amount of earnings the vendor is claiming the business earns is sustainable—and the quality of those earnings—before you finalize the deal. Being aware of the quality of earnings isn't just about looking at the numbers, although that's an important indicator. It requires developing a thorough understanding of the target's business. "We spend several hours talking with management of the target company before we even look at the detail behind the financial statements," says John Caggianiello, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto."That conversation gets us the information we need to determine the risk areas for our client: the corporation or the Private Equity firm planning to buy the business, or the Bank or alternative lender wanting information for decision-making purposes." Various areas of the business are explored in the meeting, such as how the target company acquires customers, how sales are made, what kind of capitalization policy is used and how inventory is handled. "You also want to ask questions that can bring things to light that you'd never otherwise discover, such as what keeps them up at night or how they would grow the business if money was no object," says John. The idea is to learn how the business operates so that financial, customer and vendor analyses can be done with an understanding of where the risks lie. "A quality of earnings review doesn't need to look at every single little thing. That's not cost- or time-effective," says Vic Kroeger, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto. "You need to look at the right things. We tailor the investigation to focus on specific areas, those of highest risk for the buyer." While the process always involves pinpointing certain areas, how you look at those areas will change depending on the type of business. For example, Accounts Receivable Aging will always be examined but, says Vic, if you know, through a conversation with the management of the target company, that one customer makes up 75 per cent of sales, you can focus your work on how quickly that customer pays, calculate the percentage his...

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