Skip to main content
Pen pointing at data on screen

Understanding Sustainability of Profits in M&A Transactions

It is crucial to understand exceptional profit factors before an M&A transaction.
banner background

When contemplating a potential investment in or acquisition of a company, buyers will evaluate numerous financial and operational trends and metrics during the due diligence process. As part of a quality of earnings analysis, careful consideration must be given to exceptional factors leading to revenue and earnings levels that may not be sustainable in the long term. In other words, analysis of the sustainability of financial results should contemplate not only one-time or nonrecurring items, but broader trends and factors that may not be repeatable.

When a company demonstrates consistent profit margins year to year, there may not be a lengthy conversation around the topic of margin sustainability. However, even with consistent annual margins and growth that may appear normal, consideration should be given to whether such trends are accurate or if factors exist that mask a potential underlying decline in a company’s sustainable results. As such, decision makers should ask questions to understand the business drivers behind a company’s reported results not only when revenue and/or margin change significantly but also when financial results appear to follow consistent trends.

This article presents four considerations— (1) exogenous factors, (2) inflationary impacts, (3) employee utilization and succession, and (4) nonrecurring revenue sources—and a framework for evaluating the sustainability of revenue and earnings for both buyers and sellers during mergers and acquisitions (M&A) transactions.

Exogenous Factors

A plethora of external factors outside management’s control could cause an enterprise to experience swings in revenue and profitability, including issues related to commodity prices, the weather, its supply chain, macroeconomic factors, currency, and regulatory developments.

A prime illustration of the impact of exogenous factors is supply-chain disruptions causing both temporary cost increases that may or may not have been passed on to customers and an inability to fulfill customer orders in a timely manner, resulting in potentially lost sales. However, such supply-chain disruptions may also result in above-normal revenue growth as a company fulfills a built-up customer sales order backlog. Another example would be a company whose business is partly based on responding to weather events, as it would be expected to generate higher revenue and margin levels in years with more extreme weather. A final example of an exogenous factor is a business that may experience a short-term benefit from regulatory enactments, such as a company assisting customers with one-time implementation of Europay, Mastercard, and Visa (EMV)-compliant point-of-sale systems.

Inflationary Impacts

Inflation is driving additional conversations in M&A transactions. The level of inflation in a year may not impact the accuracy of a financial statement under GAAP, but it may have a significant impact on normalized sales, margins, earnings before interest, taxes, depreciation, and amortization (EBITDA), and working capital analyzed during an acquisition. As Forvis Mazars previously discussed in the article, “Normalizing Inflation in M&A Transaction & Considerations for Financial Due Diligence,” both buyers and sellers should evaluate the impacts of inflation on earnings and working capital, including how to normalize operating results. Key considerations for evaluation include sales, expenses and margins, inventory standard costing, customer contracts and costs to fulfill, and working capital.

For example, a distributor reported higher margins due to having large amounts of inventory (reflected in a high days inventory outstanding (DIO) and inventory aging) and carried lower unit costs in a period of rising inventory prices. The company was able to sell through this inventory at higher sales prices as it increased prices to customers in advance of having to purchase inventory at increased costs. Margins then decreased as the company sold higher-cost inventory at the sales prices that had been raised prior to incurring increased inventory costs.

Employee Utilization & Succession

Employee utilization or succession issues can exist across all industries. In situations with short-term fixed employee costs, such as a primarily salaried employee base, increases in workload or production without a commensurate increase in headcount can drive revenue and margin growth. In these circumstances where headcount growth lags sales growth, decision makers should evaluate whether the higher employee utilization levels are sustainable in the long-term. This can be highly impactful in professional services firms and other businesses with time and materials contracts where utilization levels are a critical profitability driver. Similarly, temporary gaps in employment for key individuals not yet backfilled with new hires may be achieved by unsustainable workloads borne by existing team members, artificially boosting profitability. Finally, a company’s owner may be a primary driver of revenue or recent growth. Ensuring this individual either continues providing similar services post-transaction or successfully transfers customer relationships and operational knowledge to existing or new employees is critical to maintaining sales and profitability levels.

Nonrecurring Revenue Sources

While nonrecurring, significant customer orders or one-time projects may lead to better business outcomes in a given year, these one-time events often result in a difference in buyer and seller expectations. The seller wants credit for the associated EBITDA, while the buyer believes the revenue and earnings levels may not be repeatable. Buyers must be careful in acquiring a company at its peak and analyze sales and revenue data to assess whether there are revenue outliers which, if not replaced, could lead to a future decline in revenue and earnings. For instance, a company may have significant customer revenue from a long-term project that was recently completed and not have visibility into how or if that revenue will be replaced. Similarly, a business may have a non-core project that is not a typical part of ongoing operations. As another example, a company could lose a key customer that contributed to profitability over the last year but would not be relevant to a buyer post-transaction.

A Framework for Identifying Sustainability Issues

As both buyers and sellers consider factors that may impact the sustainability of profits, below are some potential strategies for pinpointing the source of sustainability issues:

  • Conducting a trend analysis on whether revenue is declining in recent months, i.e., may have peaked in prior months such that last twelve months (LTM) is still higher than prior years but the run-rate trend is downward
  • Understanding what revenue looks like by (1) customer (churn analysis), (2) division, (3) product category, and (4) market/geography, and discussing management’s outlook going forward
  • Differentiating revenue that is highly recurring or one-off, i.e., project-based revenue that has to be replaced or large, unusual sales that may be one-time only
  • Performing a price-volume analysis and/or cost-volume analysis to quantify the impact of price versus volume changes on total revenue and/or cost
  • Analyze monthly commodity and/or raw material cost trends
  • Inquire regarding exogenous factors impacting performance
  • Analyze monthly expenses relative to revenue, understanding the impacts of cost changes and employee utilization

Evaluating the sustainability of both revenue and earnings—from both the buyer’s and seller’s perspectives—is an essential step during the M&A process. Whether buying or selling a business, our team at Forvis Mazars is here to help you navigate questions that may arise to help you make an informed decision. For more information, reach out to a transaction advisory services professional at Forvis Mazars.

Related FORsights

Like what you see?
Subscribe to receive tailored insights directly to your inbox.