Dealing in the transaction market space requires a deep understanding of the terms and acronyms that are commonplace when discussing a potential sale, merger, or acquisition of a business. This article provides a background of what a quality of earnings report entails and explores why it is requested as part of a transaction. It also presents two case studies in which the quality of earnings significantly impacted the transaction.

What Is a Quality of Earnings Report?

A quality of earnings report is one piece of the transaction process requested by a buyer and seller to validate both internal analysis and normalization adjustments to earnings before interest, taxes, depreciation, and amortization (EBITDA) that is included in pitchbooks and other transaction materials. This report provides an understanding of financial performance of the entity in question and helps validate normalization adjustments to EBITDA.

Why Does EBITDA Matter?

EBITDA is used in the income approach to valuing a business. Specifically, weighted average adjusted EBITDA based on historical or forecasted results is the starting point to which a transaction multiple is applied. The transaction multiple (the transaction price divided by the weighted average adjusted EBITDA) is based on recent transactions for similar businesses to arrive at an expectation of value under the income approach.  

The multiplier effect means that any normalization adjustment has a greater impact than under the income approach, which increases the importance of understanding all adjustments to EBITDA. Transaction multiples will vary by the specific nature of the industry, market appetite, competition, geographic location, synergies, and the quality of management.  

Normalization Adjustments

Normalization, or the process of bringing or returning something to a normal condition or state, provides great insight into the purpose of this part of the transaction process. A seller wants to present its company’s true profitability, while a buyer wants to exclude one-time increases to the operational results that will not be repeated in the future.  

Types of Normalization Adjustments

Two categories of normalization adjustments may be referred to in a quality of earnings report: general normalization and due diligence adjustments.  

General normalization is the removal of one-time impacts that will not reoccur in the future. It more accurately presents the income recognized and expenses incurred by the business during a normal year. Examples of general normalization adjustments include:

• Salaries and benefits for company owners could be too high, too low, or simply not expected to be needed in the post-transaction corporate structure.
• Related party transactions could be consummated at a value that cannot be found in an arm’s length transaction. This includes items such as rent or other services provided by related parties that may be too high, too low, or not expected to be incurred moving forward.
• Discretionary expenses such as charitable contributions or other items that aren’t required for the company to operate.
• Other nonrecurring or extraordinary income or expenses that can cover a variety of situations.

Next, due diligence adjustments are those necessary to reflect a company’s financial statements in accordance with generally accepted accounting principles (GAAP). Common adjustments related to due diligence include:

• Application of the revenue recognition standard may require adjustment to the timing or amount at which a transaction can be recorded.
• Accruals for expenses that haven’t been reflected in the financials shown. These could be simple timing items in closing books, but larger adjustments may relate to recognizing a warranty or payroll accrual.
• Other cash to accrual adjustments that may be required.

The key for both general normalization and due diligence adjustments is not only to understand and challenge the nature of these adjustments, but also to investigate and analyze the records to find missing adjustments.  

These examples have likely sparked questions about different types of transactions that may fit in these categories. A seasoned professional providing quality of earnings services facilitates the evaluation of whether these adjustments are properly included and at what amounts. More importantly, a quality of earnings professional analyzes a wealth of corporate data in drafting the quality of earnings report and identifies what may be missing from the normalization adjustment list.

The Report

The EBITDA normalization table is by far the most stressed item included in a quality of earnings report. The remainder of the report is equally useful in understanding other elements of the business being sold, including:

• Special payment terms from customers or to vendors
• Aging of balances in both accounts receivable and accounts payable
• Components of significant balances or transactions
• Analytical analysis of the income statement, from concentrations to margin or variance analysis

A quality of earnings report provides confidence and understanding of the business and the numbers upon which the transaction value is based. This confidence and understanding provides a route to a successful transaction, realistic expectations of the transaction, and also helps prevent a bad transaction from occurring.  

Getting beyond the background of quality of earnings reports, the following case studies illustrate nuances of a quality of earnings engagement related to a post-pandemic environment as well as some common industry adjustments and errors.