The purpose of the quality of earnings analysis is to make adjustments to the seller’s EBITDA so the buyer has a full understanding of the company’s financial performance.
A variety of adjustments can be made to EBITDA, but they can be grouped into 3 categories:
1. Nonrecurring/nonoperational adjustments
2. Pro forma/normalizing adjustments
3. Accounting adjustments
Nonrecurring (or nonoperational) adjustments remove the effects of one-time gains or losses. This could include:
• Asset impairments
• Gains or losses from the disposal of fixed assets
• Restructuring costs (e.g., lease termination fees, severance costs)
Pro forma/normalizing adjustments update historical revenues/expenses to reflect recent changes. For example, what if the cost of rent, salaries, or raw materials recently increased? This wouldn’t be reflected in historical financial statements since accounting is backward-looking, but these changes would affect the company’s profit going forward. Thus, EBITDA should be adjusted to reflect these higher costs.
Accounting adjustments can occur for a variety of reasons. If the company is a small firm, it’s possible they use cash-basis accounting. Thus, the seller’s EBITDA can be adjusted to be consistent with accrual accounting. Accounting adjustments might also need to be made if the company incorrectly applied accounting principles, perhaps by capitalizing costs that should have been expensed or improperly recognizing revenue to inflate profits.
A good QoE analysis will catch these issues and adjust the seller’s EBITDA accordingly.
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