In the aftermath of the global financial crisis, corporate decision-makers are seeking new and enhanced tools to better scrutinize their capital and investment decisions. The Quality of Earnings analysis is fast emerging as a central component in addressing this need.
The appreciable differences between standard GAAP accounting and the preparation of a Quality of Earnings report should preclude a decision-maker from substituting one for the other, rather, both provide benefits for distinct reasons.
At the heart of a Quality of Earnings report is the adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) proxy. Adjusted EBITDA is central to corporate decision-making regarding mergers and acquisitions because of its tangible value in determining future profitability and reaching a purchase price, which is often set as a multiple of the Adjusted EBITDA. GAAP guidelines do not address calculating an Adjusted EBITDA, therefore, a significant amount of expertise and discretion is necessary on the part of the preparer.
The adjustments utilized in computing an Adjusted EBITDA fall into five major categories: (1) One-time, non-recurring; (2) Run-Rate; (3) Non-cash; (4) Out-of-Period; and (5) Carve-outs.
Examples of one-time adjustments include extraordinary professional fees or a non-recurring sale. Recently, classifying restructuring and severance adjustments as one-time adjustments has become more prevalent.
Run-Rate adjustments seek to normalize the peaks and troughs a business experiences and spread costs over a broader period than found under GAAP principles.
Non-cash adjustments, such as warranty expenses, effectively exclude income or expenses that do not impact cash flows.
Out-of-Period adjustments primarily consist of the release of reserves or other accrued liabilities.
Carve-outs are of particular significance in mergers and acquisitions. Carve-out adjustments give buyers and sellers a tool to both use stand-alone adjustments, as well as remove superfluous costs, in order to better target the vitality of core business operations post-transaction.