October 13, 2021
Due Diligence: Quality of Earnings
When I was a starting out as a deal lawyer, I heard a lot of folks on deal teams talking about “quality of earnings” assessments. I had no idea what they were talking about, and was afraid of looking stupid, so I didn’t ask. If you’ve got a suspicion that some of the younger folks who work with you might act the same way that I did – or if you are one of those younger folks – check out this Rock Center Partners blog. It provides a nice overview of quality of earnings diligence and why it’s important. Here’s the intro:
When a quality of earnings is prepared, it’s usually best summarized in a schedule. One that shows the amount of EBITDA that a target company initially reported, which is then adjusted to reflect the financial impact of issues that were identified in due diligence. In other words, by using a company’s reported EBITDA as the starting point, each issue that’s identified can then be quantified in terms of the financial impact that it would have on EBITDA. The issues can either be presented as increases or decreases to that EBITDA in order to arrive at a ‘normalized’ amount.
For the most part, there’s no specific rule for how normalized EBITDA should be calculated. Which means, there’s a certain amount of subjectivity in it. And while sometimes it’s pretty clear when something is misleading and should be shown in a different way for an investor, sometimes it’s not, and it can involve a bit of judgement. This is where having the right mindset to thinking about what should and shouldn’t be an adjustment becomes very important.
If you take the view that a business’ current level of EBITDA needs to be representative of what a buyer should be able to expect going forward in a business, then it’s usually pretty clear when something is misleading and should be adjusted. Except, sometimes it can be a little more technical than that. So, in this article, we’ll explain some of the different issues that can cause quality of earnings adjustments.
The blog then walks through the kind of issues and adjustments that buyers need to focus on, including non-compliance with GAAP, non-recurring items, seller add-backs, reserve reversals & changes in reserve methodologies.
– John Jenkins