When it’s time for investors to consider a target company’s current financial position and historical financial performance, they turn to financial due diligence and quality of earnings reports for a reliable third-party analysis. In this blog, we highlight the part of the due diligence process that relates to normalizing adjustments to a business’ cash flows.
In conducting a thorough evaluation of a potential business acquisition, it is vitally important to understand the nature and magnitude of the business’ cash flows. Whether from the perspective of the buyer or seller, the earnings of the business are essential to determine the appropriate purchase price or multiple to be used in pricing the deal. Furthermore, it is in the best interest of both sides of a transaction to accurately represent and clearly understand the benefit stream(s) driving the pricing of the transaction.
To do so, professionals consider the application of normalizing adjustments to a company’s historical (or projected) cash flows in order to reflect the true economic position and results of operations of the target company. These adjustments are necessary to remove the effect of certain accounting principles that may contradict or imperfectly reflect economic reality as well as eliminate certain discretionary, non-operating, or non-recurring items that may distort the reported results of operations.
Normalizing adjustments are particularly crucial with respect to evaluating the earnings potential of a company under the transaction scenario being contemplated by the parties (i.e., evaluating what the company’s financial results will most likely look like on a go-forward basis post-transaction).
Most commonly, financial due diligence includes procedures whereby normalizing adjustments are proposed to adjust the target’s earnings before interest, taxes, depreciation and amortization (“EBITDA”). EBITDA is a commonly utilized benefit stream in transactions as it considers results before interest expense and taxes to mitigate effects of varying capital structures and special tax situations, respectively.
Moreover, EBITDA is premised on results before depreciation and amortization to adjust for varying levels of capital investment, variable amounts of depreciable/amortizable assets, and differing depreciation methods that may be used by companies.
The following list highlights some of the more common normalizing adjustments that are considered or applied during financial due diligence:
- Discretionary / Personal Expenses: Are there discretionary expenses that management currently incurs that do not impact the day-to-day operations of the business? Are any personal expenses paid by the company on behalf of a business owner that would not be necessary on a post-transaction basis?
- Executive Compensation: Are any officers paid at levels that are not consistent with what the market would bear for a reasonable replacement? Does the letter of intent stipulate what the compensation for select officers will be post-transaction? Are there any officers that are not involved in the day-to-day operations (or any part of the business) who could be removed without affecting the company’s financial results? Are there family members who receive compensation but are not actively involved in the company’s operations?
- Related Party Transactions: Does the company have related party transactions that will not occur on a go-forward basis or will occur at higher or lower transaction amounts? Does a related party own the real and/or personal property on which the subject company operates? Does the company currently have a “sweetheart” rent rate as a result of that related party relationship?
- Extraordinary / Non-Recurring Income and Expenses: Have any other income or expenses been received or incurred that are not expected to recur in the future or do not relate to the core operations of the business (e.g., legal settlements paid or received)?
- Out-of-Period Expenses: Have accounting entries, policies and methodologies been consistently applied throughout the interim and year-end periods? Have accounting methodologies changed over the last several years? In addition, it is important to consider the impact of necessary closing entries that may or may not have been booked as of an interim date (e.g., bonuses are not accrued for until year-end).
The aforementioned items are just a few of the normalizing adjustments that are frequently identified during a financial due diligence assignment. Each project requires the diligence team to have detailed discussions with management (and the company’s external accountants in many instances) to properly identify all applicable normalizing adjustments.
It is important to note that many business owners can be hesitant to disclose certain personal/discretionary expenses; however, it is in these owners’ best interests to identify and assist in quantifying these amounts as they frequently represent incremental cash flows available to a hypothetical buyer. Moreover, these increases can have a meaningful impact on the purchase consideration as it is common for a hypothetical buyer to base a purchase price on an EBITDA multiple. For example, if the letter of intent stipulates a purchase price based on 5.0x the amount of trailing 12-month (“TTM”) normalized EBITDA, every dollar that results from a normalization adjustment to EBITDA is multiplied by five, resulting in more money landing in the seller’s pocket.
Identifying normalizing adjustments is a vital component to executing a successful deal.
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