M&A Vocabulary – Experts explain: Normalized Earnings

published on 27 March 2024 | reading time approx. 2 minutes

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the 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 or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

A normalized earnings analysis is essential to M&A processes, as it aims to present the underlying earnings capability of a company adjusted for the impact of non-operational and non-recurring effects or structural changes incurred recently / envisaged post transaction, so called pro-forma adjustments.

Considering a hypothetical scenario where an investor has only the following information about Company A and Company B, all other factors being equal, to make an investment decision:

It is likely that the investor either would not have an investment preference due to same margins profile or would be willing to invest in Company B, which has a higher nominal result. However, reported earnings might be distorted by non-operational and non-recurring effects. Profits from the sale of fixed assets is a common example for non-operational income.

Considering the same scenario presented above and all else being equal, in case Company B has sold fixed assets during FY22 and realized a profit of TEUR 2.000. Such impact should be considered by a potential investor and adjusted for:

Irrespective of how well a company is being managed, including their book-keeping / accounting function, there will always be events that will not result from the core business.

As a result, normalized earnings are an indispensable analysis in M&A processes, as it is the basis to forecast the future and as such the foundation for business valuations. Buyers are not willing to pay for non-recurring results.

Therefore, having a normalized result is an acceptable basis for company valuations and purchase price negotiations. In this respect, events like land sales, release of provisions, legal disputes, and financial gains or losses amongst others do not relate to the core business which requires an in-depth normalization analysis.

Such review is commonly performed during a Due Diligence process, usually carried out by the buyer’s advisor. In this process, the advisor will analyze the quality of earnings of the target company and will adjust the impact of any non-operational or non-recurring effects. In this way, investors will be able to assess the target’s underlying profitability.

Moreover, the normalized earnings analysis can reveal a target’s “true” potential. A clear example of it can be seen from a company with a positive operational result, however one-off items are negatively impacting net earnings, i.e. the underlying profitability would be higher after adjustments. Finally, it is also important to point out that a normalized analysis might be performed at different earnings levels. For instance, adjusted EBITDA is commonly used in M&A transactions and, despite EBITDA should only include operational results by nature, some extraordinary events may also be registered on its reported level. In other industries, adjusted EBIT might be used as depreciation of fixed assets is an important aspect for the buyer.