Financial due diligence (FDD) is a process that requires a thorough and comprehensive analysis of a target company's financial performance and sustainability. Such analysis often includes a review of financial statements, trial balances, management internal reports, breakdowns of revenue, expenses, assets, and liabilities as well as a series of interviews with Management, among other information that can help investors or potential acquirers make informed decisions about the target company's value. One essential component of the FDD is the assessment of recurring EBITDA, which is also called the Quality of Earnings (QoE) analysis.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) normalization is a method used in financial analysis to remove the effects of certain non-recurring, non-operating, or irregular items from the target’s income statement (or P&L) to provide a more accurate reflection of its underlying earnings. It is a critical component of the FDD process because it helps potential buyers identify any unusual items that can distort the company's earnings potential and recurring operating results.
The normalization process consists of analyzing the target company's P&L to identify non-operating, unusual, or non-recurring items, accounting irregularities, or management practices that may not align with industry standards and adjusting them accordingly. Examples of these include gains or losses from the sale of assets, one-off project costs, restructuring charges, misallocation of management fees, expenses related to reorganizations, acquisitions or divestitures, over-provision and subsequent release of the excess provision and capitalization of costs that should have been expensed, among others. Additionally, given certain presentation matters or accounting practices commonly used, there might be some operating or recurring items wrongly recorded below EBITDA. Once identified, these items are added back or deducted to arrive at a more accurate representation of recurring earnings.
QoE adjustments typically are divided into accounting, non-recurring, reclassification and pro-forma adjustments.
- The purpose of accounting adjustments is to correct the reported EBITDA for items that did not receive the appropriate accounting treatment or were not correctly valued in the trial balances.
- Non-recurring adjustments intend to correct the reported EBITDA for items that may not be related to Target’s activity or are one-off and non-recurring in nature and distort the reported earnings of the business (the treatment is typically in compliance with GAAP).
- The purpose of reclassification adjustments is to present an alternative accounting treatment to that which was applied by management either in the management accounts or in the trial balances. These are normally differentiated from accounting errors in that the treatment given by management to these items in the statutory accounts is following local GAAP. Here, some operating and recurring items recorded below EBITDA are usually identified and added back.
- Pro-forma adjustments are presented in order to illustrate what the reported EBITDA might be if certain events had taken place at a different point in time (e.g. simulating what the EBITDA would have looked like if a restructuring program had taken place at the beginning of the year) or had never taken place (e.g. adverse conditions which had a material impact on the business).
EBITDA normalization is crucial for investors because it allows them to compare the earnings potential of different companies and assess their value more accurately. When comparing companies, investors can use normalized EBITDA figures to adjust for specialized or non-recurring expenses to determine whether the target company's earnings power is comparable to other companies in the industry. Earnings adjustments may affect modeling assumptions as well.
The pro-forma EBITDA could bridge the earnings gap between the current year and the next year and influence the investor’s view on the value of the business and it may be used by banks as part of their lending evaluation, too. A Quality of Earnings analysis can help investors identify any potential red flags early on that may indicate areas of concern and any risks that may affect the sustainability of a company's earnings, allowing the investor to make an informed decision.
Moreover, a QoE analysis also helps identify any trends or issues that could impact the business from a commercial or operating perspective going forward. For example, a company that is highly dependent on one or a few large customers or suppliers may be exposed to significant risk if its customer or supplier’s business undergoes a downturn, or for a company that is part of a group (a typical carve-out situation), it is not uncommon to provide or receive goods or services from entities under common control at rates that are not indicative of the market and, likely, will not be kept in a post-deal scenario.
In conclusion, performing the QoE analysis is probably the most essential and relevant step in the FDD process. These analyses help investors identify significant risks and opportunities associated with the investment opportunity, adjust valuation models, and negotiate the most favorable price for the transaction. Furthermore, it provides a more transparent approach to evaluating a company's performance, which enhances investors' confidence in the ability to deliver consistent returns over the long term. Usually, the issues identified as part of a QoE analysis in an FDD process may lead to the investor adjusting the purchase price of the company or reassessing the viability of the investment.