Acquisition Due Diligence: Quality of Earnings and the Cost of Quality

Inglewood was engaged by the prospective buyer of a family-owned contract manufacturing company that was struggling after nearly fifty years in business. The owner was looking for an opportunity to exit and retire. Given the range of issues facing the company, the parties agreed a full quality of earnings analysis was required, one covering financial, operations, quality, and technology due diligence. The buyer and seller split the cost of the analysis so that each would have a copy if the deal fell through.

Why This Deal Needed a Quality of Earnings Analysis

At a high level, the company faced four interlocking problems:

• Serious quality issues, including scrap, customer returns, and charges that put the entire company at risk.
• Declining sales and margins.
• Significant management and labor problems tied to an absentee owner and, for the previous five years, a general manager who ran the business into the ground.
• Strategic Data Management gaps that prevented proper monitoring of operations and management of the business.

Together, these issues had eroded virtually every component of the income statement and balance sheet, and cash flows along with them.

How We Approached the Work

The Inglewood team conducted extensive interviews from senior management down to key shop-floor, value-stream managers and supervisors. We reviewed management practices and controls across the business process, studied job profitability, performed a detailed analysis of operating results, and examined the financial and quality management systems from a Strategic Data Management perspective. We then evaluated the company's go-forward options and what each would mean for the quality of earnings. In a situation like this, acquisition due diligence has to go beyond the financial statements.

What We Found

Quality

• For the last five years, management focused on keeping production running at all costs, in an apparently misguided effort to increase absorption rates.
• Inventory from production overruns was held in hopeful anticipation of future sales, and large volumes of scrap parts were hidden in finished goods inventory and gradually written off.
• The total cost of quality over the last four years, including a final write-off when the owner returned, was nearly $3 million, an order of magnitude above the costs when the owner was previously involved.

Sales

• Sales had declined by nearly 20%, and there had been virtually no price increases in five years beyond selected material-cost pass-throughs.
• The quoting process relied on a series of error-prone manual data inputs and outdated quality and efficiency rates.
• No qualified sales or business development team members remained.

Labor

• A number of key management and operations positions were vacant or facing imminent retirements.
• During the general manager's five-year tenure there were no labor pay-rate increases to stay competitive in the market. The result: lower morale, higher turnover, more entry-level than skilled labor, and little focus on training.

Strategic Data Management

• The company had invested in a robust accounting/ERP system but never completed the implementation of multiple modules, leaving a mix of old home-grown applications, Excel spreadsheets, and a newer system that was not kept up to date.
• Without the discipline of actively capturing quality data, tracking value-added job labor costs, and managing operations to that data, quality problems compounded into scrap write-offs and a severe financial impact.

Because of the recent years of losses and declining operations, the company would likely sell at a highly distressed value unless someone could demonstrate, with numbers, how it could recover and what the potential financial outlook might be. That is exactly what this due diligence process and quality of earnings analysis gave both buyer and seller: a clear-eyed view of the risks and the rewards of the deal.

What We Recommended

Inglewood's key recommendations, among others, were these:

• Sell idle equipment. Monetize idle, under-utilized, and excess capacity equipment to bring in additional cash.
• Raise prices. Increase pricing wherever possible to bring in additional cash.
• Rebuild the team. Invest in replacing selected key staff positions in sales, business development, and operations.
• Pay for skill. Invest in labor pay rates to keep skilled workers and attract a more skilled labor force.
• Finish the ERP. Upgrade the accounting/ERP system and implement the modules required to properly manage the data needed to run the business.

In effect, we laid out a sequence: raise cash first, then make strategic investments in the business that would pay for themselves by significantly reducing the cost of quality.

The Outcome: A Sale Within a Year

The initial prospective buyer was not able to come to an agreement with the seller. But management immediately implemented Inglewood's recommendations, and just as immediately began to see long-desired improvements in the business. The end result: the company was sold within a year, delivering a successful business exit for the owner.