Case 088Earnings quality and adjustmentsWarm up
A company's adjusted EBITDA of Rs 300 crore excludes exceptional charges that have appeared in each of the last five years. At 12x EBITDA, how much value depends on believing the label?
1The situation
Girikanta Engineering, an invented maker of industrial pumps, presents adjusted EBITDA of Rs 300 crore in its information memorandum. The adjustment excludes exceptional charges, which the company says are one-off. The notes to the accounts show exceptional charges of Rs 40, 35, 50, 45 and 38 crore over the last five years: a plant restructuring, a warranty settlement, an impairment of a loss-making unit, a legal provision and another restructuring.
A buyer is prepared to pay 12x EBITDA. Its analyst asks you what the adjustment is worth and whether it should be accepted.
2Your task
What value difference does treating the charges as recurring make at 12x, how would you test the company's claim, and what should the buyer do with the number?
Quick check
At 12x, roughly how much value hangs on accepting the adjustment?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About Rs 499 crore: 12x of Rs 300 crore is Rs 3,600 crore, while 12x of the Rs 258.4 crore left after the average charge is Rs 3,101 crore. A charge that appears five years running, never below Rs 35 crore, is an operating cost with a different label. Test each item for cause and cash, but the pattern itself is the evidence. The buyer should price on about Rs 258 crore of EBITDA, or accept the adjustment only for items it can show will not recur under its own ownership.
Step 1What makes a charge exceptional?
A household that budgets for groceries and rent but calls every hospital bill, wedding gift and scooter repair an exception will find that the exceptions arrive every year and the budget never balances. A charge is exceptional only if it is outside the ordinary course of the business and unlikely to recur; a charge that recurs under changing names is part of running the business. Girikanta's five charges have five different labels, which is exactly what you would expect from a company that restructures, settles and impairs as a matter of routine. The adjusted EBITDAEBITDA after management removes items it regards as one-off or non-cash; the adjustments are the company's own choices and are not audited as a total. figure is the company's view of itself without those costs.
Step 2What does the label cost at 12x?
The arithmetic is short and the multiple does the damage. The average charge is Rs 41.6 crore, 13.9% of adjusted EBITDA, so treating it as recurring takes EBITDA to Rs 258.4 crore and value from Rs 3,600 crore to Rs 3,101 crore. Put the other way, a buyer who pays Rs 3,600 crore and then finds the charges keep coming has paid 13.9x the EBITDA the business actually produces. Over the five years the charges total Rs 208 crore of real money, mostly cash, that left the company while the adjusted figure said it had not.
| 12 | the EV to EBITDA multiple the buyer is paying |
| 40 + 35 + 50 + 45 + 38 | the five years of exceptional charges, Rs crore |
| 41.6 | the average charge, treated as a recurring cost |
Step 3How would you test the company's claim?
Go through the five items one at a time with three questions: what caused it, was it cash, and would it recur under the buyer's ownership. A restructuring that appears twice in five years is a cost of being in a business that keeps needing to restructure; a warranty settlement is a product cost; a legal provision for a dispute that is now closed may genuinely be one-off. Impairments are non-cash, but they record that an earlier investment did not work, which says something about capital allocation even if it says nothing about this year's cash. Then ask for the same table over ten years, and for the cash flow statement, where exceptional cash costs cannot hide. The notes to the accounts and the auditor's report on key matters are the places to read, not the information memorandum.
| Year | Charge, Rs crore | Label | Cash? | Likely to recur? |
|---|---|---|---|---|
| 1 | 40 | Plant restructuring | Yes | Yes, it recurs in year 5 |
| 2 | 35 | Warranty settlement | Yes | Yes, a product cost |
| 3 | 50 | Impairment | No | Non-cash, but a sign of past capital misallocation |
| 4 | 45 | Legal provision | Partly | Depends on the dispute |
| 5 | 38 | Restructuring again | Yes | Yes |
| Average | 41.6 | Treat as a cost until shown otherwise |
Step 4What should the buyer do with the number?
Price on the EBITDA the business has actually delivered and let the seller argue items back in. Start from about Rs 258 crore, Rs 3,101 crore at 12x, and accept an adjustment only for an item the seller can show has ended, such as a legal case that is closed. If the buyer accepts half the adjustments, value is about Rs 3,350 crore. The limitation is that the buyer may genuinely run the plants without the restructurings; if so, the saving belongs in its synergy case, where it is tested, rather than in the seller's EBITDA, where it is assumed.
Where candidates lose it
The common loss is accepting the adjustment because each charge, taken alone, has a plausible story. The interviewer is testing whether you look across years rather than at one item; five stories in five years is a pattern, and the pattern is what the multiple prices.
The second loss is comparing the yearly charge with the price instead of capitalising it. Rs 41.6 crore looks small next to Rs 3,600 crore; at 12x it is Rs 499 crore, 14% of the price.
What the interviewer asks next
- The seller offers to accept a lower multiple, 11x on adjusted EBITDA, instead of a lower EBITDA. Is that the same thing?
- How would you treat a genuinely one-off cash charge in a DCF rather than a multiple?
- Which non-cash items in adjusted EBITDA would you accept without argument, and why?
Company names and figures are illustrative.