In today’s mergers and acquisitions (M&A) market, buyers and sellers are often applying a “COVID adjustment” in an attempt to normalize earnings and net working capital, and to illustrate how the pandemic affected the operations and financial results of a given company. But quantifying the financial effects of COVID can be challenging for a variety of reasons.
Although some companies were affected negatively, others benefited from COVID-related surges in demand. Or there were hybrids of some benefits along with some negatives. Understanding the financial effects of COVID-19 also isn’t as simple as looking at how a company was performing before March of 2020 and comparing those results to today.
For many companies, COVID’s effects varied considerably over the past 12 months as the pandemic, customer demand, supply chains and market conditions evolved. Many businesses had an understandable short-term focus on keeping their doors open before shifting gradually to building and refining sustainable operations for today’s markets.
Beyond the revenue effects, any companies’ balance sheets were altered significantly during the onset of the pandemic. Common impacts include a company’s cash position, inventory, accounts receivable and accounts payable.
Comparable to income statement run-rate adjustments, a pre- and post-COVID examination of trends is required, with the mindset that some areas may need to be monitored for anticipated changes in the run-rate of the company’s working capital investment.
The challenge is compounded by the difficulty of defining a company’s prospects going forward when so much uncertainty remains in the current climate. For some companies, “normal” conditions change weekly or monthly, which makes it hard for a potential purchaser to define a go-forward run rate.
Any adjustments have to be made based on conditions today, with the understanding that companies won’t see normal conditions for a while. And for most organizations, a post-pandemic normal is likely to be different than what they experienced before COVID-19 arrived.
These adjustments largely have to be made with little, or no, historic financial data to influence them. That said, two months of financials is better than one month, and one month is better than zero months. But guidance from three years of trending data isn’t applicable to today’s conditions.
To develop and communicate adjustments, you need to make sure the adjustments are:
It’s also important for buyers and sellers to go beyond the immediate effects to try to capture any COVID impacts that might not be obvious at first glance.
For example, an e-commerce retailer may have had supply chain and fulfillment issues that harmed its customer service and generated negative ratings online. Those low ratings, in turn, increased the company’s advertising costs as major platforms imposed a poor-quality surcharge that meant it cost considerably more to reach a sizable audience.
And due to the volatility in working capital accounts caused primarily by the onset of the pandemic, we are seeing working capital targets based on a more recent, shorter historical monthly average or other alternative ways.
Considering the secondary effects of a COVID-related implication on a company’s operations and financial results can provide important insights that can lead to more effective adjustments during the due diligence process.
With careful consideration of COVID’s effects on a company’s balance sheet, working capital and revenue, as well as the secondary impacts, buyers and sellers will be better prepared to develop and discuss appropriate COVID-19 valuation adjustments to potential transactions.
If you have any questions or want to learn more about preparing for M&A, contact our experts.
