An earnings bridge is a simple tool with a serious job: reconcile reported results to a level of earnings you can underwrite, finance, and manage. Think of it as a path from what shows up in the statements to a steady, defendable run rate. Most of the time the focus is EBITDA, but the same discipline applies to EBIT and free cash flow.
The bridge has three layers. First, normalize history by stripping out discrete, non-operational items and aligning accounting. Second, build a pro forma run rate that includes actions you control and have executed or contracted by signing or closing, plus dis synergies and transition services that will hit on day one. Third, restate the result under the lender’s covenant definition, which may be more generous. Each layer has a clear purpose, and mixing them muddies valuation and debt capacity.
Context that defines the bridge’s job
Assume a sponsor is carving out a niche industrial business with operations in several countries. LTM revenue is 300 million dollars and EBITDA is 24.0 million dollars under US GAAP. The deal uses completion accounts with a net working capital target and includes a TSA for IT, finance, and HR. Financing is a senior term loan plus a revolver. The lender’s draft allows add backs for cost savings reasonably expected to be realized within 24 months if certified. The bridge will anchor the investment memo, lender deck, and post close plan.
Stakeholder incentives you must align
- Sellers’ push: Argue for add backs tied to non recurring costs and try to shift dis synergies to the buyer. They prefer pricing certainty.
- Buyers’ filter: Accept documented one offs and run rate savings that are executed or contracted, haircut anything else, and insist on dis synergies.
- Lenders’ lens: Underwrite to their own EBITDA definition that includes add backs for reasonably expected savings. Sponsors try to align that definition to the investment case to reduce drift.
- Regulators’ guardrails: Enforce discipline around non GAAP measures. Reconcile to GAAP or IFRS, label clearly, and avoid cherry picking. IFRS 18 formalizes disclosures for management defined performance measures starting with 2024 issuance.
The three layer bridge that keeps you honest
Layer 1 – Normalized EBITDA
Start with reported LTM EBITDA of 24.0 million dollars. Adjust only items that are discrete, documented, and not expected to recur in the next 12 to 24 months. Undocumented adjustments risk audit challenge.
- Restructuring: +3.2 million dollars for a plant consolidation completed in the period. Board approved, completion certified, no further severance expected.
- Legal settlement: +1.1 million dollars for a resolved legacy claim. Executed settlement and release in hand.
- Cyber remediation: +0.6 million dollars. Incident closed and insurance separately booked.
- Expired subsidy: -0.9 million dollars as a government program ends.
- Warranty accrual: -1.0 million dollars to align with a three year failure rate. Policy adjusted prospectively.
- Temporary surcharge: -1.5 million dollars related to a single customer, expiring next quarter per contract.
- Bad debt normalization: -0.4 million dollars to revert to a three year average.
- FX neutrality: -0.3 million dollars to remove a one time gain.
Net, normalized EBITDA is 24.8 million dollars. That number is the foundation, with no promises about the future.
Layer 2 – Pro forma run rate EBITDA
Reflect actions under your control at signing or closing. Include the pain from dis synergies and TSAs. Present both first year pro forma with TSA drag and steady state after TSA exit. Lenders and investment committees look at both.
- Procurement savings: +1.8 million dollars from a negotiated 150 basis point COGS reduction on a 120 million dollar materials base, effective next month under an executed supply agreement.
- Headcount actions: +2.3 million dollars incremental run rate. Notices served for 40 roles and severance recorded in Layer 1. Half year savings realized in LTM, so add the remaining half to reach a full year effect.
- Lost group rates: -1.2 million dollars as insurance and rebate dis synergies hit post separation.
- TSA fees: -3.6 million dollars for nine months at 0.4 million dollars per month for IT, finance, and HR. Exclude these fees in steady state.
Results: first year pro forma EBITDA equals 24.8 + 1.8 + 2.3 – 1.2 – 3.6, or 24.1 million dollars. Steady state pro forma EBITDA equals 24.8 + 1.8 + 2.3 – 1.2, or 27.7 million dollars. Keep that split front and center. Cash in year one looks like 24.1 million dollars, while the 27.7 million dollar case is earned only after TSA exit and delivery of savings.
Layer 3 – Covenant EBITDA
Covenant math follows the credit agreement, not your memo. In the draft, management equity awards add back 1.6 million dollars of non cash stock compensation per year. The lender may also allow the full annual effect of executed headcount actions, not just the unrealized portion, which adds 2.2 million dollars beyond Layer 2. If allowed, Covenant EBITDA equals 27.7 + 1.6 + 2.2, or 31.5 million dollars. Use it for compliance and liquidity planning. Do not underwrite cash to it. The year one cash profile remains closer to 24.1 million dollars because TSA costs pull forward expenses while stock comp is non cash.
Working capital and price mechanics you cannot ignore
Working capital normalization belongs in both the bridge and the completion accounts. The 1.0 million dollar warranty accrual increase reduces EBITDA and lowers closing NWC. If the peg is 45.0 million dollars and closing NWC is 43.8 million dollars after policy alignment, the buyer recovers 1.2 million dollars through the adjustment. That avoids paying twice. Put the accounting policies used to set the peg in the SPA schedules to reduce ambiguity and improve close certainty.
Pair the EBITDA bridge with a cash bridge that includes capex, cash taxes, and working capital. When TSA and dis synergies weigh on earnings, lenders often look through to cash EBITDA and free cash flow. A clean debt schedule and monthly cash walk are essential to prove liquidity under stress.
Carve out dis synergies and TSA design that withstand scrutiny
Dis synergies are not a rounding error. Expect lost rebates and purchasing leverage, higher insurance rates without the parent’s umbrella, incremental governance costs under sponsor ownership or for a future listing, and duplicate costs from parallel systems. TSAs should be specific, time bound, and priced at cost plus a reasonable margin. Termination rights should sit with the buyer on notice periods that match the integration plan. Show TSA costs by function and target exit dates in the bridge, then tie those dates to the integration plan.
Documentation map that makes the bridge auditable
- SPA or APA: Definitions of NWC, net debt, treatment of transaction costs, and pricing mechanics.
- TSA: Service scope, SLAs, fees, duration, and extension or termination mechanics.
- QoE: Third party analysis of revenue, margins, operating expenses, non recurring items, and NWC, plus data books and trial balance tie outs. See this overview of a Quality of Earnings report for context.
- Pro formas: If the buyer is a registrant, Article 11 requires adjustments that are directly attributable, factually supportable, and with continuing impact.
- Credit agreement: Lender EBITDA definition, caps, and reconciliation from GAAP to covenant EBITDA with labeled adjustments.
- Integration plan: Owners, dates, costs to achieve, and measured savings by category.
Accounting and reporting guardrails that protect credibility
- GAAP or IFRS vs non GAAP: Keep reconciliations clean, labels consistent, and prominence balanced. Avoid adjustments that change recognition principles.
- IFRS 18: Brings management defined performance measures into formal disclosures. Adjusted EBITDA will face more scrutiny in IFRS regimes.
- Leases: IFRS 16 lifts EBITDA versus US GAAP presentation. Align treatments if the target and acquirer report under different regimes.
- Stock based comp: Non cash but recurring and dilutive. Show valuation multiples both including and excluding it.
Tax items that affect normalized earnings
- Transaction costs: Remove from LTM EBITDA and avoid double counting in net debt.
- Discrete tax items: Keep them out of adjusted net income views. EBITDA is pre tax, but materials tend to drift.
- Transfer pricing: If new intercompany charges are coming, model and include them as dis synergies.
- Withholding and treaties: They do not change EBITDA but matter for cash. Capture in the cash bridge.
Risks and edge cases to control
- Evidence standard: No document, no add back. Contracts, board approvals, invoices, and service notices belong in the data room.
- TSA slippage: Exits slip and eat savings. Treat TSA exit as its own project with penalties for delay.
- Dis synergy creep: Small losses on insurance, freight, and rebates add up. Use broker quotes, not estimates.
- Revenue traps: Do not add back lost revenue without firm orders and capacity to deliver.
- Backlog quality: Exclude cancellable backlog from run rate claims.
- Price cost lag: Procurement wins can be offset by commodity resets or switching costs. Model both sides.
- FX symmetry: Adjust gains and losses consistently.
- Double counting: Map each run rate saving to its enabling cost in Layer 1.
- Governance: Form a synergy committee with a standard sign off template and audit trail.
Implementation timeline you can execute
- IOI to LOI: Build a quick earnings bridge with high level sensitivities. Flag TSA needs early.
- Confirmatory diligence: Commission QoE and working capital studies. Build Layer 1 with line item support. Draft SPA schedules aligned to the bridge. Start TSA term sheets.
- Financing: Align lender EBITDA to the bridge. Negotiate caps and certification processes. Prepare a GAAP to covenant reconciliation.
- Signing to closing: Finalize TSA and integration plan. Update the bridge for stub periods and new dis synergies. Prepare the completion accounts template. Lock synergy sign off governance.
- Day 1 to 100: Implement contracted savings. Launch TSA exits. Stand up monthly reporting with a bridge that ties to the integration plan.
- Year 1: Move from first year pro forma to steady state. Consider refinancing once TSA drag lifts and covenants are comfortable.
How to argue the bridge with key audiences
- With sellers: Price off normalized EBITDA and take dis synergies through completion accounts or price reductions. Keep buyer funded savings out of the seller’s price.
- With lenders: Show three reconciliations, GAAP to normalized, normalized to steady state, and steady state to covenant. Commit to quarterly bridges and caps on pro forma add backs.
- With the board: Present returns under three cases, first year pro forma, steady state pro forma, and a downside with TSA exit slippage and 50 percent savings delivery at 18 months.
Numerical anchor summary for quick recall
- Reported LTM EBITDA: 24.0 million dollars.
- Normalized net add backs: +0.8 million dollars to 24.8 million dollars.
- Pro forma run rate items: Procurement +1.8, headcount +2.3, dis synergy -1.2, TSA nine months -3.6.
- First year pro forma EBITDA: 24.1 million dollars.
- Steady state pro forma EBITDA: 27.7 million dollars.
- Covenant adds: Stock comp +1.6, headcount full year uplift +2.2.
- Covenant EBITDA: 31.5 million dollars.
Controls that keep the process disciplined
- Trial balance build: Build from the trial balance and GL detail. Tag every adjustment to an account and period. Maintain a binder with contracts, approvals, and invoices.
- Owner certification: Require an owner certification for each run rate item with description, timing, dependencies, and risks.
- Monthly tracking: Track delivery monthly. Dashboard realized versus plan. Reforecast if delivery slips. Escalate TSA overruns.
- Public readiness: Prepare auditor ready files if public reporting is possible. IFRS 18 raises the bar for adjusted EBITDA disclosures.
Comparisons and alternatives to consider
- Locked box vs completion accounts: Locked box reduces post close debates but shifts working capital focus into leakage definitions, while completion accounts suit cases with policy harmonization needs.
- EBITDA vs cash EBITDA vs FCF: In TSA heavy carve outs, cash diverges from EBITDA. Use cash EBITDA for liquidity underwriting and build a separate bridge to free cash flow that includes capex, taxes, working capital, and TSA timing. Build the cash view inside a robust three statement model.
- Earn outs: If tied to EBITDA, the definition must follow the bridge. Spell out add backs, TSA treatment, dis synergies, and restructuring. Do not hand the seller buyer funded synergies unless bargained for.
Fresh angle: a confidence score that quantifies risk
Add a Bridge Confidence Score next to each adjustment and the overall bridge. Score each item 1 to 5 based on evidence quality, controllability, timing, and cash conversion. A 5 is a signed contract with an implemented change and trailing results. A 3 is a board approved plan with vendor quotes and a clear workback schedule. A 1 is aspiration without documentation. Weight the score by dollar impact to surface concentration risk. Then publish a monthly improvement target and hold owners accountable. This simple scorecard sharpens debate and reduces wishful thinking.
For lenders, include a one page summary that shows Covenant EBITDA alongside cash EBITDA and free cash flow, plus a short note on certification status for each pro forma item. This reduces drift between your underwriting case and the lender’s compliance view and aligns with best practice around EBITDA add backs.
Closing Thoughts
Normalize first, then layer in only those run rate items you control and have executed or contracted. Align definitions across the SPA, lender documents, and management reporting and reconcile them in writing. Underwrite to cash, not just Covenants. Govern the process with evidence and monthly updates. Used this way, the earnings bridge is not a slide for a lender deck. It is a management tool that powers returns after close.