M&A Vocabulary – Understanding the Experts: “Quality of Numbers” and “Quality of Earnings”

Quality of Numbers and Quality of Earnings are two areas of investigation within Financial Due Diligence.

In a first step, the due diligence advisor assesses the reliability of the available financial records (Quality of Numbers) of the target company (target) by examining, for example, whether:

• correct accrual accounting takes place (including intra-year)
• figures from different sources match (e.g., monthly sales reports vs. annual financial statements)
• what discrepancies exist between external accounting and management reporting and what the reasons for these are.

This field of investigation becomes particularly relevant if the planned transaction is a carve-out—the separation of a specific business activity and associated assets or companies from a corporation. In this case, it must be checked whether the delimitation of the target is comprehensible and plausible (e.g., allocation of costs for necessary central services such as accounting and HR) and to what extent intercompany charges might influence the figures for the carve-out.

If a financial forecast is part of the scope of the due diligence, it is also examined for its mathematical accuracy and its reconcilability with historical figures.

Ultimately, the recipient of the due diligence report can form a picture of how much “caution” should be exercised regarding the target company’s figures and can already weigh which actions he intends to implement after the transaction to improve the Quality of Numbers.

Building on the findings regarding the Quality of Numbers, the Quality of Earnings can then be analyzed during the due diligence. In this analysis, which is often central to due diligence, the informative value of historical figures for a selected earnings metric (Earnings) is examined with regard to the underlying profitability of the target company. In practice, EBITDA is usually used as the earnings metric. To estimate the profitability underlying the business model, the selected earnings metric is adjusted, for example, for items that are not inherent to business operations or are considered non-recurring, such as:

• book gains from the sale of assets
• expenses for unusual legal disputes
• allocations to and reversals of special provisions or specific bad debt allowances
• income and expenses from transition effects due to changes in methods
• other operating income and expenses attributable to other periods
• unusually high expenses for persons related to the owners
• severance and bonus payments to (former) employees that exceed the usual scope.

If the target company has grown inorganically in the recent past or has been restructured, it may also be necessary to consider corresponding pro-forma adjustments to present comparable figures for all historical periods.

The result of the Quality of Earnings investigation is ultimately a normalized earnings figure (normalized Earnings), which often serves as the basis for purchase price considerations.

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