Financial Due Diligence - Quality of Earnings Overview
Quality of earnings is often the most important part of financial due diligence for businesses valued based on EBITDA. In these cases, a potential investor is interested in what the sustainable cash earnings are for the business and understands that earnings, as reported, likely needs to be adjusted.
This article is written to cover the basics of the quality of earnings analysis.
EBITDA, As Reported
EBITDA is defined as Earnings before Interest, Taxes, Depreciation and Amortization. It's the most common measure taken when assessing quality of earnings and is considered a good proxy for net operating cash flows.
EBITDA is not typically presented in the income statement for statutory reporting purposes, but can be calculated from reported amounts as follows:
EBITDA = Net Income + Depreciation + Amortization + Interest + Taxes
EBITDA = Operating Profit + Depreciation + Amortization
The quality of earnings starts with establishing EBITDA, as reported, which is reconciled to audited or reviewed financial statements when available.
EBITDA, As Adjusted
After EBITDA, as reported, is established, the next phase of a quality of earnings analysis involves identifying potential adjustments. There are two primary adjustment categories - normalization adjustments and proforma adjustments.
Normalization adjustments include two primary types - non-recurring or one-off adjustments and adjustments related to accounting changes.
Proforma adjustments take into consideration what-if scenarios, changes in business drivers and other items. As you would expect, these adjustments often require significant judgment.
In addition to quantified normalization and proforma adjustments, other items are often identified but not quantifiable. These are also presented for consideration.
The result of the Quality of Earnings Analysis will then present the following:
EBITDA, As Reported
+/- Potential Adjustments
EBITDA, As Potentially Adjusted
+/- Proforma Adjustments
EBITDA, As Proforma Adjusted
Other Potential Considerations
If the selling company (Target) has made adjustments to its reported EBITDA, then another line item to the Quality of Earnings may include EBITDA, Management Adjusted.
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, or financial adviser who is familiar with all the relevant facts.