BDO Knows: Transaction Advisory Services

Purchase Price Wars - EBITDA vs. Adjusted EBITDA and Why it Matters

Although compliant with US GAAP, the reported results of a potential acquisition target,  often do not reflect the sustainable run rate of the company's cash flows. This article defines the difference between reported results and quality of earnings and how a  quality of earnings analysis can potentially impact the purchase price and set the expectations of value of a potential acquisition.

Quality of Earnings (“Q of E”) in the context of a potential acquisition has a different meaning than quality of earnings from an audit perspective.  Put simply,  quality  of  earnings  in  a  transaction  environment  represents  the  sustainable  run-rate  of  earnings  before  interest,  taxes, depreciation  and  amortization,  or  EBITDA, derived  from  normalization  adjustments  to reported  results.  Adjusted  EBITDA  is  a  critical element  for  buyers  in  building  a  valuation model  and  is  often  the  basis  for  purchase  price negotiations.

Acquisitions are typically priced based on a multiple of EBITDA.  If EBITDA as reported is not critically analyzed and adjusted, the buyer may pay too much for the target, lowering potential returns and negating the value of potential synergies.

The multiplier effect is generally what separates relying on audited financial statements from normalized results.  Audited financial statements  are  helpful  as  a  starting  point for  reported  results,  but  they  are  typically  of limited  use  due  to  their  reliance  on  materiality for recording adjustments to EBITDA. Additionally, audited financial statements do not make adjustments for one-time, non-recurring events; rather they seek to make sure that these events are accounted for correctly.

For  instance,  assume  a  target  won  a  significant legal  settlement  and  reported  a  gain  of  $1 million.  The target’s auditors will review the transaction for the appropriate accounting treatment.  If  this  gain  was  not  normalized  in  the context  of  a  Q of E   analysis,  the buyer  might  pay  a  multiple  of  that  gain.  On the other hand,  assuming  the  $1  million  was  a  loss  rather  than  a  gain,  EBITDA  should  be  adjusted  to  reflect  the  sustainable run-rate.  It is important to note that adjustments can go both directions depending on the nature of the item. 

Most  audit  programs  establish  a  materiality level  for  errors  or  passing  on  potential adjustments,  usually  based  on  a  percentage  of  net  income,  assets,  revenue  or  other  metric  the  particular  auditor is  comfortable  making  as  the  threshold.  As a result, proposed adjustments or  errors  that  fall  below  the  materiality  threshold  are  noted  in  the  audit  workpapers,  but  are not generally  recorded.

Here again the multiplier effect can be significant.  Assume the materiality level for audit purposes was $500,000.  Assuming  the  target  should  have written  off  $300,000  of  inventory  at  year end but  passed  on  the  entry  because  it  was  below the  materiality  threshold,  the  buyer  could  pay  a multiple  of  $300,000  too  much  for  the  target.

There  are  three  primary  components  to  a  Q of E  analysis  which  is  usually  calculated  using the  most  recent  trailing  twelve  month  period:

  • EBITDA as reported;
  • Management Adjustments;
  • Potential Adjustments based on due diligence procedures.


EBITDA as Reported

EBITDA  as  reported  is  not  difficult  to  compute  and  is  generally  not  a  point  of  contention  between the  buyer  and  seller.  The  analysis  begins  with  net income  as  reported  and  adjusts  net  income  for depreciation  and  amortization  expense,  interest income  and  expense,  taxes,  and  other  cash  or non-cash  items  to  arrive  at  EBITDA  as  reported.  The  key  is  to  make  sure  the  amount  reconciles  to the  company's  financial  statements.

Management Adjustments

If  the  target  uses  advisors  or  is  a  sophisticated  seller,  adjustments  will  generally  be  provided  in  an effort  to  normalize  EBITDA  to  what  management considers  the  sustainable  run-rate  of  EBITDA.  A healthy  skepticism  should  be  used  to  critically analyze  each  proposed  adjustment  to  determine both  the  amount  and  appropriateness.  Buyers should seek supporting documentation (invoices, payroll registers, etc.) wherever possible to confirm the amounts.  For  instance,  if  management proposes  an  adjustment  for  a  one-time  severance expense,  ask  for  supporting  payroll  documents to  confirm  the  amount. Additionally,  buyers should  gain  an understanding  of  the  nature  of  the reduction  in  force  (RIF)  and  ask  whether  positions were  back-filled  subsequent  to  the  RIF.  If so, an adjustment to management’s proposed adjustment might be appropriate.

Potential Adjustments

When  analyzing  for  potential  adjustments,  the  buyer  should  take  into  consideration  whether management  appears  aggressive  or  conservative, how  management  might  be  impacted  by incentive  compensation  or  other  integrity  matters. Additionally,  the  quality  of  the  accounting  records could  negatively  impact  the  buyer's  ability  to quantify  and  support  potential  adjustments.

Keep in mind that not all adjustments are clear cut.  For  instance,  suppose  a  buyer  is  performing due  diligence  on  a  tuxedo  rental  company  in March  2000  and  the  buyer's  analysis  indicates  that  revenue  for   December  1999  was  significantly higher than  that  of  December  1998.  After  further inquiry,  it  is  determined  that  the  significant increase  in  revenue  (included  in  the  trailing twelve  month  period)  was  due  to  the  millennium celebrations,  which  will  not  occur  again  for  another 1,000  years.  Adjustments  of  this  kind  require  a critical  analysis  of  historical  growth  and  margin trends  to  determine  an appropriate  adjustment amount  that  both  the  buyer  and  seller  can  agree to. Professional  skepticism  and  judgment, understanding  of  the  target’s  business  and  industry cycles  and  a  thorough  analysis  are  critical  to performing  a  proper Q of E  analysis.

Below  is  just a sample  of  the  types  of  adjustments found  in  a  Q of E   analysis:

  • Litigation settlement or expenses
  • Management fees to private equity owners
  • Owner personal expenses
  • Unusual bad debts or inventory write-offs
  • Severance or other restructuring expenses
  • Unusual or non-recurring incentive compensation
  • Gains or losses on the sale of assets
  • Insurance recoveries and reimbursements
  • Departures from US GAAP
  • Unrecorded proposed audit adjustments
  • Impact of year-end adjustments (true-ups) on interim periods
  • Corporate allocations versus proposed transition services agreement (carve-out)
  • Reversal of reserves built in prior periods
  • Income statement misclassifications (operating items recorded in other income/expense)
  • Impact of acquisitions or divestitures

In summary, a thorough Q of E analysis conducted by an experienced team of professionals is one of the keys to confirming the underlying basis for the purchase price in a transaction. Experience and expertise in identifying adjustments impacting EBITDA and an understanding of the nuances of the company’s business is instrumental.