March 4, 2021

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

Inglewood was recently hired by a prospective buyer of a family-owned contract manufacturing company that was struggling recently after nearly fifty-years in business, and the owner was looking for an opportunity to exit the business and retire.  Due to the range of issues facing the company, it was decided that a Quality of Earnings analysis was required covering financial, operations, quality and technology due diligence. The prospective buyer and seller agreed to split the cost of the analysis so that they both would have a copy in case the deal fell through.

Some of the high-level challenges that the company was facing included:

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

The above items had caused significant deterioration in virtually every component of the income and balance sheet, and in cash flows. 

The Inglewood team conducted extensive interviews with a number of employees from management down to key shop floor, value-stream managers and supervisors; reviewed management practices and controls throughout the business process, studied job profitability, performed a detailed analysis of the company’s operating results, reviewed their financial and quality management systems from a Strategic Data Management perspective and evaluated the company’s go forward options and the impact on the Quality of Earnings Analysis. 

Our key findings regarding the company’s issues included:

  • Quality
    • For the last five years Management focused on keeping production running at all costs in an apparent misguided effort to increase absorption rates.
    • Inventory from production overruns were held in inventory in hopeful anticipation of future sales; and large volumes of scrap parts were hidden in finished goods inventory and being gradually written off.
    • The total cost of quality issues over the last four years including a final write-off when the owner returned, was nearly $3M; an order of magnitude well above the costs when the owner was previously involved.
  • Sales
    • Sales had declined by nearly 20% and there were virtually no price increases in five years except selected material cost pass-through.
    • The quoting process utilized a series of error prone manual data inputs and outdated quality and efficiency rates.
    • There were no qualified sales or business development team members left.
  • Labor
    • A number of key management and operations positions were either vacant or had imminent retirements.
    • During the five-year term of the General Manager, there were no labor pay rate increases to maintain competitiveness in the market resulting in lower morale, higher turnover, more entry level vs. skilled labor and a lack of focus on training.
  • Strategic Data Management
    • The company had invested in a robust Accounting/ERP system but failed to complete the implementation of multiple modules resulting in the mix of old home-grown applications, Excel spreadsheets and the newer system which was not kept up to date with the latest version.
    • The discipline of actively capturing and managing quality data, value-added job labor cost tracking, and managing the operations to the data led to extensive quality issues, write-offs of scrap parts and a severe financial impact.

Because of the recent years of losses and declining operations, the sale of the company would likely be at a highly distressed value, unless it could be demonstrated and calculated how they could recover and what the potential financial outlook might be.

This thorough due diligence process and Quality of Earnings analysis was essential for both the buyer and seller to understand what the potential risks and rewards could be with the acquisition and sale of the company. Accordingly, Inglewood’s key recommendations were, among others, as follows:

  1. Sell some idle, under-utilized and excess capacity equipment to help bring in some additional cash.
  2. The company needed to raise prices wherever possible to bring in additional cash.
  3. Invest in replacing selected key staff positions for sales/business development and operations.
  4. Invest in labor pay rates to keep the skilled laborers and attract a more skilled labor force.
  5. Invest in upgrading the accounting/ERP system and implementing the modules required to properly manage the data required to run the business.

Effectively, Inglewood was recommending a set of key opportunities to raise cash to get started, and then make some strategic investments in the business which would pay for themselves by significantly reducing the costs of quality. 

Although the initial prospective buyer was not able to come to an agreement with the seller; management immediately implemented Inglewood’s recommendations and equally immediately started to see long-desired improvements in the business.  The end result was that the business was sold within a year achieving a successful business exit for the owner!