Quality of Earnings:

What Quality of Earnings means

A Quality of Earnings analysis is a targeted financial review that assesses the sustainability, predictability, and cash-generating nature of a businessʼs earnings. It goes beyond the reported financial statements to consider whether the underlying performance is representative of the businessʼs future operating capability.

The analysis is not an audit. An audit considers whether financial statements are fairly presented in accordance with the applicable reporting framework; a QoE analysis asks a different question—what level of earnings is likely to continue if the business changes hands.

1.   Start with reported EBITDA

Reported EBITDA may include items that do not reflect the ongoing economics of the business. These can include one-off gains or losses, non-operating income, owner-related expenses, accounting timing effects, or exceptional expenditure. Reported EBITDA is therefore rarely considered in isolation.

A QoE analysis typically begins with reported EBITDA and identifies adjustments needed to present a maintainable earnings base. The objective is not to increase or decrease EBITDA for its own sake, but to distinguish recurring operating performance from items that distort the underlying trend.

2.  Test the quality of revenue

Revenue quality is central to the analysis. A buyer should understand whether revenue is recurring, contract-based, seasonal, project-related, or dependent on a small number of customers. Revenue disaggregation, customer concentration, product mix, and gross-margin trends can reveal patterns that aggregate financial statements obscure.

Common questions include:

•      Is revenue recurring or driven by one-time contracts or windfall sales?

•      Are there customer or product concentration risks?

•      Is revenue recognised consistently with the underlying commercial arrangements?

•      Are there cut-off issues or timing effects that flatter a reporting period?

•      Are margins sustainable once volume, pricing, and cost changes are considered?

A one-time project, a large non-recurring sale, or revenue from a discontinued product line may increase reported EBITDA in a period but may not represent earnings a buyer can rely upon going forward.

3.   Normalise expenses with evidence

Expense adjustments should be supported by underlying records, contracts, payroll data, invoices, and management explanations. Common categories include one-time legal settlements, restructuring costs, transaction-related fees, non-cash charges, and owner-related expenses.

A simple illustration shows the structure of a normalised EBITDA bridge:

The example is illustrative only. Each adjustment should be supported, clearly labelled, and assessed for whether it is genuinely non-recurring. A cost that appears in several periods, even if management describes it as exceptional, may be part of the businessʼs normal operating cost base. 

4.   Assess cash conversion

Earnings that do not convert into cash require closer scrutiny. A QoE analysis commonly reconciles EBITDA to operating cash flow and examines receivables, inventory, payables, accruals, and the timing of cash movements.

For example, a business may report strong EBITDA while receivables increase materially, inventory builds up, or payables are stretched before a transaction. These movements can improve reported earnings or cash metrics in the short term without representing sustainable performance.

The analysis should consider seasonality, customer payment behaviour, supplier terms, factoring arrangements, and whether working-capital movements are structural or temporary.

5.   Establish normalised working capital

Working capital is often as important as EBITDA in determining transaction economics. The buyer needs to know the level of working capital required to operate the business normally, and the seller needs certainty about the amount that will be delivered at completion.

A working-capital peg is a target level agreed in the transaction documents. It is commonly derived from normalised historical working capital over a period such as the last twelve months, adjusted for seasonality and unusual movements. At completion, the actual working capital is compared with the peg, resulting in a purchase-price adjustment.

6.   Identify debt-like items

Net debt is not limited to bank borrowings. A QoE analysis should identify obligations that behave economically like debt and may reduce equity value, including certain accrued liabilities, deferred consideration, unfunded obligations, and other contractual commitments.

These items sit outside EBITDA but can materially affect the bridge from enterprise value to equity value. Identifying them early helps avoid late-stage disputes over the final purchase price. 

7.   Distinguish adjustment types

A well-prepared QoE analysis separates adjustments by their nature and reliability. Management may identify items it considers non-recurring, while diligence may identify additional normalisations or accounting issues. Pro forma adjustments, such as anticipated cost savings, are more judgemental because they depend on future execution.[1]

Pro forma adjustments should be clearly separated from historical normalisations. A buyer should not treat an unexecuted cost-saving plan as though it were already part of sustainable earnings.

Closing perspective

Quality of Earnings analysis is about understanding the earnings a buyer is actually acquiring. It connects reported results to underlying revenue quality, sustainable cost structure, cash conversion, working-capital needs, and debt-like obligations.

A credible normalised EBITDA figure is not simply the highest defensible number. It is the figure best supported by evidence and most representative of the businessʼs recurring