M&A Vocabulary – Explained by the experts: Quality of Numbers and Quality of Earnings

from Maximilian Egger

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner each present an important term from the English specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

The Quality of Numbers and the Quality of Earnings are two fields of analysis during financial due diligence.
As a first step, the Due diligence consultant evaluates the reliability of the available numbers (Quality of numbers) from the target company, by examining: 

• whether time-based accruals have been booked correctly (including during the year)
• whether numbers from different sources match (e.g. monthly sales figures vs. annual financial statements)
• which variances exist between the external financial statements and the management accounts and how these are justified.

This analysis is of particular relevance when the planned transaction is a carve-out, involving splitting off a specific business activity and its associated assets or companies from a company. In such a case, it must be checked whether the perimeter of the target was defined clearly and logically (e.g. allocation of costs for required central services such as accounting and personnel management) and to what extent, if relevant, intercompany charges may affect the figures for the carve-out.

If a business plan is part of the scope of the due diligence, it becomes part of the analysis and the due diligence checks its mathematical accuracy as well as its coherence with past figures.
 
Finally, the reader of the due diligence report will gain a clear picture as to with how much “caution” the numbers from the target company must be taken and can already weigh up what measures he or she plans to implement after the transaction to improve the quality of numbers.

Based on the findings on the quality of numbers, the due diligence can then analyse the quality of earnings. In this analysis, which is often at the core of a due diligence, we examine what significance the past numbers for a given earnings figure have as to the underlying profitability of the target company. In practice, the earnings figure most commonly used in this context is EBITDA. In order to estimate the underlying profitability of the business model, the chosen earnings figure is adjusted, e.g. by eliminating circumstances which are not inherent to the business model, or which are considered to be non-recurring, such as:

• book gains from the sale of assets
• expenses for unusual legal disputes
• creation and reversal of provisions or specific allowances for bad debts
• income and expenses arising from the effects of changes in methodology
• other operating income and expenses that are attributable to other periods
• unusually high expenses for parties related to the owner
• severance payments and bonus payments to (former) employees that are higher than normal.

If the target company has recently grown through acquisitions non-organically or has been restructured, it may also be necessary to consider pro forma adjustments to produce comparable figures for all past periods.

The result of the analysis of the quality of earnings is a normalised earnings figure, which is often used as the basis for purchase price negotiations.