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). This blog post 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.
As a result, while we spend most of our time in diligence honing in 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.
In a series of three blog posts, our goal is to increase the understanding of how misstatements (or even an accurate balance sheet) can affect EBITDA. In the first post we will focus on 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 regularly 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.
These are just a couple of examples that can be identified through a balance sheet analysis. Our next post will cover fixed assets and the balance sheet.
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 SOC 1 & SOC 2 engagements, due diligence 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.