Quality of Earnings Report 101: Proof of Cash
Author: Elliott Holland
Why you need to assess Proof of Cash during the due diligence process
Key Takeaways
A Quality of Earnings report is critical to the due diligence process when you buy a business
A Quality of Earnings report helps you analyze trends and identify risks in the target company
Quality of Earnings also helps you ensure the accuracy of the target's financial records by validating the cashflow or EBITDA of the business through Proof of Cash
Proof of Cash highlights discrepancies between revenue and expenses in operating records and bank accounts
Using bank statements to establish Proof of Cash provides the most reliable analysis of a business's financials
A Quality of Earnings report plays a significant role in the due diligence process. It makes sure the numbers are solid in the business you want to acquire and that you know exactly what you're investing in. As implied by the name, a Quality of Earnings report helps you assess the quality of a target firm’s earnings (profit, SDE, etc.). Are they sustainable and lasting or a temporary fluke? Do they come from a diverse customer base or are you putting all your eggs in one risky basket?
Investing in a Quality of Earnings is essentially like paying a mechanic to check out a used car before you write the check to a private seller to buy it. You can't necessarily believe everything someone tells you when they're selling you a business or a used car. So, in both cases, you pay an expert to take a look under the hood and give you the low down. You wouldn’t trust a $20,000 purchase of a car until you took it to a mechanic. You certainly can’t trust a $1,000,000 investment without your “business mechanic” or Quality of Earnings provider.
Ultimately, a Quality of Earnings report tells the unique story of a business. It uncovers both risks and the potential for success. A key component of this report focuses on Proof of Cash, and this article will help you understand what that means.
What is Proof of Cash?
Proof of Cash shows how a company's cash receipts and disbursements align with its recognition of revenue and expenses. To create a Proof of Cash report, we compare the business's bank statements to its financial reports. (This is just one element of the Quality of Earnings report.)
Why are there differences between bank and financial records?
There are always going to be differences between bank statements and financial records. Generally, the cash that gets deposited into the bank doesn't line up with the business's revenue on paper. Pass-through items such as sales tax or advance payments will cause cash deposits to exceed revenue, while accounts receivables will reduce the cash going into the bank compared to the revenue recognized.
While some differences are expected, significant differences can be a sign of big trouble. The Proof of Cash section of the Quality of Earnings report can uncover errors or omissions in the accounting records. It provides you with the most reliable analysis of the company's financial situation.
Why is Proof of Cash important?
The bank's version of a company's profits is always more reliable than financial statements. Remember, businesses generate financial statements internally. They may skew the numbers in their favor. You should never exclusively rely on a company's interpretation of its financials.
To return to the used car analogy, would you believe everything the owner told you about the vehicle, or are you going to grab a CarFax report and talk with an independent mechanic? The seller's interest is themselves, not you. They want the deal to go through, and they'll often say anything to make that happen.
Proof of Cash provides you with an independent analysis of the business's financials. It ensures their financial records are accurate. This is especially important if the business hasn't been audited or reviewed by an independent party.
How do you read a Proof of Cash report?
The most amazing part of the Proof of Cash report is that it’s super easy to read. No, really!
The analysis compares deposits in the bank, the net value of certain transfers to revenue, and the net value of items that aren’t calculated on a cash basis and won’t match the bank records. Then it compares withdrawals from the bank to net transfers to expenses and the net value of items that aren’t calculated on a cash basis. Bank statement revenue minus bank statement expenses equals bank statement profit. We compare this to revenue from the financials minus expenses from the financials, which is profit from the financials. Then bank statement profits are compared to financials profits and the difference is presented as a percentage of revenue. Differences under 3% to 5% are usually acceptable.
How do you assess the differences between the cash and operating numbers?
Ideally, the differences should be small. A CPA with acquisition experience can help you identify the appropriate numbers for your situation. But for example, if there's only a difference of a few percentage points on a company with a half million dollars in revenue, you can assume the financials are accurate.
Keep in mind that the numbers can fluctuate significantly from month to month. For example, in one month, the cash-basis expenses from the bank may be 20% higher than the expenses from the operating records. But the next month, the difference may be -15%.
Don't focus too much on the monthly numbers. Instead, look at the averages. Pay particular attention to the average difference from the rolling 12-month period.
When you assess the Proof of Cash, you can feel confident about your investment and make a well-informed decision about your acquisition. Without these details, you go into the deal blind and reliant on the current owner's opinion of their business. You put yourself and your money at risk.
Let Guardian Due Diligence build your confidence
If you're thinking about buying a business, we want you to feel confident, and we understand that due diligence plays a significant role in building your confidence. But unfortunately, there aren't a lot of options for investors focused on smaller deals. They often have to choose between overpriced Quality of Earnings reports designed for private equity firms or resort to cheap options that put their deals at risk.
At Guardian Due Diligence, we leverage our extensive experience in the acquisition space to help you get the best outcome possible. Our services are customized for first-time buyers and self-funded searchers. Want to ensure the numbers are solid before you sign the letter of intent? Then, download a Quality of Earnings sample report to learn more or schedule your free Deal & LOI review at www.offerfromelliott.com.