3 Easy Steps to Analyze the Profit per Product/Service in Quality of Earnings
Author: Elliott Holland
Assessing the margin, looking for missing expenses, and bringing in industry knowledge are key steps in analyzing the Profit per Product or Service in Quality of Earnings.
Key Takeaways
Due diligence is the process of verifying information provided to you by the business seller, including cash flow and other financial data
Profit per Product or Service indicates the business’s margin for each product or service a company provides
Three easy steps to analyze the Profit per Product or Service:
Align all expenses to a product or service
Do the math
Bring in industry knowledge (what’s missing?)
Entering into a business investment is no small feat. Aside from factors like your goals and budget, you have to consider how successful the business will be in the long term based on the information you have about its past and present.
Before signing the contract and moving forward with an acquisition, you need a detailed analysis of the business’s financial information. Sellers aren’t always forthright about their numbers, unfortunately, so you need to do some digging to make sure you’re getting the great deal you think you are.
The Quality of Earnings analysis (or QoE) and its key analysis components are a must for due diligence, including assessing the profitability of products and services. This guide will cover the basics of due diligence for business buyers and dig into three easy steps for performing the Profit per Product or Service analysis in the QoE.
What does due diligence mean?
When you’re buying a business, due diligence is the process of verifying all the information the seller provided you about the business. It’s important that you assess the accuracy of this information because it could significantly impact the value you’re getting.
In most business deals, the buyer makes an offer that’s conditional on due diligence. This gives them the chance to conduct due diligence and verify everything before completing the deal. For the deal to move forward and close, all the buyer’s expectations must be met.
So, what should be verified in due diligence? Components of the business that you need to research and verify may include:
Operations
Legal issues
Financial reports
Customer information
Employee relations
Assets
A key part of due diligence is the Quality of Earnings analysis. The QoE is similar to an audit but it’s specific to business buyers. It gives you visibility into financial information about the business that indicates whether the deal is fair based on actual cash flow and holdings numbers. The QoE provides valuable information about the business’s past, present, and future, telling you exactly where it’s headed.
The business will be priced based on cash flow. If you see a discrepancy in the QoE regarding actual cash flow, and it isn’t what you expected to see, you can negotiate a lower price and end up saving a lot of money on the deal, sometimes hundreds of thousands of dollars.
Essentially, the QoE helps you understand for certain whether you’re getting a fair deal based on actual financial data about the company.
What is Profit per Product or Service?
An important component of the QoE is the Profit per Product or Service analysis. This reveals the margin the business sees for its products or services after accounting for all costs and expenses of making and selling the product or service.
Profit per Product or Service can tell you information like how well the business knows its audience and market, how successfully it’s built unique products, and its effectiveness at delivering quality services. These insights are important when assessing cash flow and other financial data in the QoE, along with the EBITDA and Proof of Cash.
3 easy steps to analyze the Profit per Product or Service in a QoE
Before closing a business deal, you need to be certain that profitability is strong based on the business’s primary products and services. An analysis of the Profit per Product or Service will tell you if margins look healthy and if the seller left out any important expenses that could change things.
These three simple steps will help you navigate the Profit per Product or Service analysis:
Align all expenses to a product or service: First, you want to align all expenses to a specific product or service. This means breaking down labor used on each product/service. It also means allocating overhead across the different products and services. Once you’ve done this, you can clearly see the full expenses of every “thing” the business sells.
Do the math: Next, do the math. Revenue minus expenses for each product or service gives you the profit. Go through this for each product/service. For extra credit, sort the products/services from most profitable to least. (Should you be offering the least profitable products/services?)
Bring in industry knowledge (what is missing?): Industry knowledge helps here. You’re looking for expenses that “should” be there but aren't. For instance, in a plumbing business, you would expect to see equipment costs and the cost of paying workers. For a company that builds products, there should be manufacturing expenses and the labor involved. So, now ask yourself, “Are all the expenses I would expect represented here already? What is missing?” The expenses that aren’t on the P&L can really hurt you!
After looking deeper at these key elements, you’ll have a much better idea about how each product or service contributes to overall profitability. Which is the best and which is the worst? It’s a crucial part of the due diligence and QoE analysis that are musts before closing a business deal.
Why work with Guardian Due Diligence?
It’s not always easy to think that sellers would misrepresent business details, but it does happen. They have incentives to indicate that their business is extremely profitable, and they’ll try to convince buyers that they’re entering into a fantastic deal.
The Quality of Earnings report helps you ensure that everything they’ve provided is accurate and that the sale price is fair. What you uncover may have a big impact on negotiations or even whether or not you want to move forward with closing.
The team at Guardian Due Diligence knows how important these deals are for a successful future. We help business buyers analyze the most important information to ensure you have a fair deal and the business is worth it.
Our team works with self-funded business investors, so they have access to the same resources private equity buyers have. We’ll prepare a QoE for you and guide you through each step of the analysis.
Schedule a call with the Guardian team today to speak to an expert.