Successfully buying a business is all about strategy. If you don’t have a solid plan going into it, the process will take control of you instead of the other way around. Instead of making decisions objectively, based on data and trends, you will find yourself making decisions based on emotions and gut feelings. Three key metrics to help you strategically navigate the due diligence process include Quality of Earnings Analysis, Quality of Forecast Analysisand Quality of Net Asset Analysis. Let’s take a closer look at each metric and see why each is essential to the due diligence process when buying a business.
1. Quality of Earnings Analysis
The Quality of Earnings Analysis is an assessment of Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA), plus any other necessary adjustments. It’s a better representation of the company’s financial performance than say, Net Income because it gives you a better picture of operational performance. A company’s quality of earnings analysis can also allow you to compare profitability between companies and industries because it cancels out the effects of financing costs and variability in accounting methods.
However, the quality of earnings analysis can be slightly misleading and can make the company look like it’s performing better than it actually is. That’s why your financial due diligence shouldn’t end here...
2. Quality of Forecast Analysis
When buying a business, it’s important to look at past performance, but it’s also important to look to the future. Where is the company headed and what can you expect to happen after the deal is complete? That’s where the Quality of Forecast Analysis comes in handy; it’s an analysis of key assumptions to determine the achievability of the company’s financial forecast. You can’t predict a company’s future performance without making some assumptions. The quality of forecast analysis will determine whether or not the assumptions made are viable and give an accurate prediction of the company’s future performance.
3. Quality of Net Asset Analysis
You can’t determine the health of a business without taking a thorough look at the balance sheet. The Quality of Net Asset Analysis looks at the balance sheet to determine what the company owns (assets), compared to what they owe (liabilities) as well as the amount invested by shareholders.
The quality of net asset analysis will look at assets such as cash, inventory, equipment and property used by the company. On the liability side, we analyze the company’s accounts payable and long-term debt. Each business will have a unique balance sheet with different accounts and varying amounts of debt. That’s why it’s so important to do a thorough evaluation of the balance sheet to determine the value of the business at any given time.
The great thing about data is that it doesn’t lie or tell you what you want to hear. It speaks the truth and gives you an objective picture of a company’s performance and value. Of course there are other metrics and trends to look at when conducting financial due diligence, but these three together give a well-rounded picture of a company’s past, future and current performance.