Variance Analysis: What the Numbers Are Really Telling You in the Long Run
Breaking down one of our many QoE tools
I would like to start this newsletter out by bragging about running an ultramarathon last weekend. It was a tough race, and I had a hard time catching my breath. Turns out, I had pneumonia on top of my asthma, so the inhaler did not do its job. Now that all the bragging is out of the way, I need to figure out how to connect it to QOE Prep so that I can justify adding this to the newsletter.
One of the interesting things about the ultrarunning community is that nobody cares about their times or paces. Every mile is so different from the last, and even the same race can feel completely different from one year to the next. If you were to ask me what I thought about the race at mile 18, I would not have nice things to say. But, if you asked me at mile 24 where we were running slightly downhill through a quiet meadow, I’d say I loved it. Ask about mile 29, and I’d get PTSD flashbacks.
When look at a business’s financials, you might be tempted to take the current snapshot as a true reflection of what’s going on. The real story, though, is likely one of ups and downs. These nuances have to be rooted out by seeing how they change over time. We call this a “variance analysis.”
What is a variance analysis?
The concept behind a variance analysis is fairly straightforward. We simply track how each line item on the P&L changes month over month, quarter over quarter, and year over year. We’ll do this both in dollar terms and as a percentage of revenue, which is what people in the industry refer to as common sizing.
The goal is to identify outliers, because in a healthy, stable business, most line items should behave predictably. Fixed costs like rent will hold steady until a lease changes. Variable costs like COGS should maintain consistent margins unless something fundamental has changed in the business. So whenever something breaks that pattern, it’s worth asking why.
Marketing expenses
One of the most common patterns we see is a sudden drop in marketing expenses in the quarter or two before a business is listed for sale. Believe it or not, this isn’t a strange coincidence. Many sellers are often coached to cut discretionary spending and do whatever they can to improve profit margins before going to market, and marketing is one of the first line items to go. On paper, the numbers will actually look great. You’ll have adjusted EBITDA margins climb, and the business appears more profitable than it has been in years.
But marketing exists for a reason (unless you’re selling Teslas). It generates leads, which drive sales, which produce revenue, which ultimately flows to the bottom line. Because marketing takes time to produce results, a buyer purchasing a business that has cut its marketing budget will likely face the dreaded J-curve that they never saw coming (unless they are subscribed to this newsletter). That inflated adjusted EBITDA needs to be normalized, and the cost of rebuilding that pipeline needs to be factored into the deal.
Staffing changes
We have also seen meaningful shifts in staffing costs as a percentage of revenue in the year leading up to a sale. When a business owner explains that labor efficiency improved due to process changes or the removal of a bad hire, that may be entirely true. But it warrants scrutiny. Lower staffing costs can also mean employees are being underpaid relative to market, or that the existing team is being pushed beyond a sustainable workload, or delayed bonuses. A buyer stepping into that environment may find themselves facing turnover, morale issues, or the need to hire additional staff shortly after closing. None of these costs or issues would be visible on a normalized P&L without a closer look.
Rent and related-party arrangements
The last example that we’ve come across has to do with rent arrangements. When a business owner also owns the building, rent becomes one of the most important adjustments in the entire analysis. We have seen cases where rent is set well below market rate. Owning the building effectively subsidizes the business’s profitability. We’ve also seen cases where it is set above market, functioning more like a personal income stream for the owner.
In either case, a buyer needs to know what the business would actually look like if they were paying fair market rent from day one. Adjusting rent to market rate is a standard part of our normalization process, and it often has a more significant impact on true EBITDA than buyers expect.
Closing
Variance analysis is just one of the many reliable tools we use to produce a Quality of Earnings report. Like all the other tools, we use variance analysis to discover the real story of a business that a cursory glance at the numbers wouldn’t provide. If you’re considering an acquisition and want to understand what the numbers are actually saying, book a call with me.