As the financial impact from COVID-19 unfolds, many companies are grappling with sudden and dramatic shifts in business demand. For some, protracted stay-at-home orders mean significantly reduced revenues, higher costs from supply chain disruption and other matters, and suppressed levels of earnings before interest, taxes, depreciation, and amortization. Companies not dealing with business closures may still be incurring additional costs to keep their workforces safe.
While the severity and length of the pandemic remain uncertain and longer-term repercussions unclear, many companies are closely monitoring the effects of the pandemic on EBITDA, a key measure often used in financing arrangements and in valuing a business. Indeed, we find some companies are adjusting EBITDA for the impact of COVID-19 and have coined the term “EBITDAC,” to represent EBITDA before coronavirus.
What other kinds of EBITDA adjustments are we seeing, and how will COVID-19 continue to affect accounting and valuations?
EBITDA is a common component of financial covenants in credit agreements. Credit agreements typically allow for a variety of adjustments, including extraordinary, unusual, or nonrecurring charges (see Table 1 below). The intention of adjusted EBITDA, which includes add-backs and deductions, is to present a normalized view of ongoing financial performance. However, the types of allowed adjustments are largely driven by judgment and negotiation and can be subject to accounting interpretation.
While the types of allowed adjustments differ by credit agreement, in general, the ability to maximize add-backs provides increased capacity for incremental debt, dividends, and investments. For companies under stress from COVID-19, additional add-backs may mean avoiding default on their credit agreements.
As companies assess the financial impact of COVID-19, we find some are starting to quantify the effects in the calculation of adjusted EBITDA. While some adjustments are likely to be viewed as extraordinary, nonrecurring, or unusual, others are more subjective and will likely need to be negotiated (see Table 2 below).
We expect that cash expenses which can be clearly identified and are directly attributable to COVID-19 will be fairly common add-backs. These types of adjustments are consistent with recently released SEC guidance for disclosing the impact of COVID-19, which we believe highlights that adjustments to EBITDA be both: (a) incremental to charges incurred prior to the outbreak and not expected to recur once operations return to normal and (b) clearly separable from normal operations.
We’ve also begun to observe certain more subjective adjustments such as those that relate to lost revenue or missing margin. These adjustments are inherently more controversial given the amounts are more challenging to isolate, quantify, and factually support. Although it is clear that many businesses are affected by closures and stay-at-home orders, it is difficult to quantify the effects on lost business and separate the effects from other drivers. In addition, there may be significant uncertainty with respect to when activity will return to pre-COVID-19 levels, if ever, for the reporting entity.
While the SEC is encouraging disclosures about the effects of COVID-19, the SEC has also reinforced its view that estimates of lost revenue from the pandemic should not be included in the calculation of non-GAAP measures.
The subjectivity of some adjustments results from the assumptions that must be made to quantify the amount of EBITDA to add back rather than the amount of EBITDA that was lost. For example, a company may easily be able to quantify the EBITDA impact of lost volumes from a contract that was terminated or an event that was canceled due to COVID-19. However, the amount to add back to EBITDA, if any, will likely be based on subjective assumptions made by management.
Adjusted EBITDA also plays an important role in merger and acquisition activity as it helps inform a company’s valuation. EBITDA adjustments for M&A purposes are often similar to those included in covenant calculations but may include a host of other adjustments indicative of demonstrating long-term value.
EBITDA and debt-based measures could also be impacted by participating in U.S. government stimulus programs, such as those provided by the Coronavirus Aid, Relief, and Economic Securities Act (“CARES Act”). This program allows eligible companies to receive forgivable loans through the Paycheck Protection Program (PPP), if certain conditions such as maintaining specified levels of payroll and employment are met.
The impact these loans will have on key financial measures could come down to whether the company meets eligibility and loan forgiveness criteria — and how loan proceeds are accounted for. This is because there is no guidance in U.S. GAAP that specifically addresses the accounting by a business entity that obtains a forgivable loan from a government entity.
We understand recent and emerging accounting interpretation suggests that loans under the PPP may be reported as either debt or an in-substance government grant, the accounting for which may differ and could impact EBITDA as well as debt-based measures. Companies that recognize loan proceeds as debt would accrue interest over the loan term. If any amount is ultimately forgiven, income from loan extinguishment would be recognized as a gain in earnings. In contrast, companies that apply grant accounting would not record any debt. (See summary in Table 3 below.) It will also be important to consider how companies consider any adjustments for loan forgiveness gains to the extent add-backs for other losses are being made.
In practice, we expect the alternatives, coupled with uncertainties about the loan forgiveness criteria, could lead to some diversity in practice around the manner and timing in which the accounting is recognized.
A number of other accounting issues have arisen from COVID-19 that could impact EBITDA. These issues include rent concessions provided to tenants impacted by the economic disruption as well as restructuring costs associated with lease exits, severance, and other disposal activities. Considering the accounting rules related to these issues may be challenging, it will be important to weigh the extent to which these items impact adjusted EBITDA. Beyond these issues, we expect to see additional other financial reporting challenges rise to the forefront.
While there is a lot of attention on the types of adjustments included within EBITDA, it is important to also take a broader perspective on COVID-19’s impact on operations, margins, and financial flexibility going forward. As companies pivot to recovery, there are still many unknowns about how deep and severe the economic and health impacts will be — and when and if demand for business returns to pre-COVID 19 levels. These unknowns include the scope and effect of further governmental, regulatory, fiscal, monetary, and public health responses. Ultimately, no single number can represent a true depiction of “normalized” performance, and it’s incumbent on the users of financial information to become more comfortable with degrees of uncertainty.
We expect to see the manifestation of COVID-19 adjustments in the capital markets for some time. Even if recovery is swift, financial covenants are generally tested on a “last-12-months” basis. Over the course of time, adjustments will become more commonplace and the types and amounts of adjustments will become more evident.
Similarly, we expect to see the effects of COVID-19 adjustments incorporated into valuations as companies demonstrate operational capacity in a post-COVID-19 world. While valuation takes a longer-term view, we anticipate the increased use of earnouts in M&A deals until the uncertainty surrounding the impact of COVID-19 is reduced with the passage of time.
Ultimately, adjusted EBITDA is and always has been subject to interpretation by the users of this information, and we believe the effects of COVID-19 will be no different. In the near-term, we expect significant diversity in the meaning of “adjusted EBITDA” as it is used both in financing and M&A. However, over time we expect to see some convergence of viewpoints based on what is accepted in the market.
Jonathan Nus and Michael Tamulis are managing directors within Alvarez & Marsal’s transactions advisory group and co-leads of the group’s capital markets and accounting advisory team.