Quality of Earnings: Determining sustainable earnings level for business

When business owners receive indication of interest from prospective buyers, it is typical to come across terms such as “Quality of Earnings”, “Reported EBITDA”, “Adjusted EBITDA and the likes especially during active due diligence. What do these terms actually mean and why is it essential for founders and business owners to be familiar with them? This article breaks down the concept of Quality of Earnings, Reported EBITDA, adjustments to Reported EBITDA and why they matter.

What is Quality of Earnings

Quality of Earnings (QoE) is an independent assessment of a target’s financial performance, to determine the true and economic level of earnings which the business can sustainably generate post-acquisition. A QoE assessment is usually carried out by an independent third-party advisor, hired either by the buyer or seller, in order to strip out items that distort the normal level of operating earnings. A QoE is normally a subset of the entire financial due diligence exercise, but usually one for the most crucial.

Why is Quality of Earnings assessment essential?

Most transactions are typically valued based on peer comparison. While intrinsic valuation methods such as discounted cash flows (DCF) are highly useful, the basis for output from intrinsic methods depends highly on the quality of assumptions. Thus, by valuing transactions based on actual performance that are investigable, such as revenue, Net income, EBITDA etc., and utilizing multiples determined from transactions of similar entities, buyers can establish a middle-ground, independent benchmark to determine the value of such transactions.

Since the value of the target (as well as the purchase consideration agreed) depends largely on the particular metric used (such as revenue, EBITDA, Net income etc.), a quality assessment of such financial metric is highly important for both sides of the transaction (the buyer and seller) to ensure the buyer is not overpaying and the seller is not underselling.

Reported EBITDA: Establishing the start line

Quality of earnings (QoE) involves an assessment of revenue and reported earnings to ensure that the reported earnings presented in the financial statements, which serve as the baseline upon which transaction adjustments are carried out, represent a true and fair view of the underlying value which it purports to represent.

To ensure the reported earnings are free from material misstatements, a DD team would usually test the following:

• Cut-off errors: Revenue is recorded when the performance obligations associated with providing a product or service to customers are satisfied. As a result, a common error that arises when assessing the earnings quality of a target is cut-off errors. That is, recording revenue in the wrong period which they belong. This typically arises when revenue involves contracts and is recorded immediately upon invoicing when the performance obligations are yet to be satisfied. In transactions, advisors should look out for aggressive revenue recognition in the transaction base year (the immediate previous year) to prevent aggressive valuation.
• Period end & transaction level errors: Advisors should check for occurrence to prevent fictitious revenue, completeness for omitted revenue, accuracy of transaction value and classification errors (non-operating gains).
• Presentation & disclosure errors: Investigations can also be directed at the allocation of value towards performance obligations that are already satisfied in a bid to overstate the true revenue.
• Inventory valuation: It is important to investigate inventory valuation. Ending inventory balance displays an inverse relationship with Cost of revenue. Hence, by aggressively increasing closing Inventory value, the cost of revenue can be minimized while EBITDA becomes inflated.

After these assessments are carried out and the reported EBITDA has been validated, then transaction adjustments can follow to establish a sustainable earnings base.

Transaction adjustments to Reported EBITDA: Obtaining Adjusted EBITDA

Once the Reported EBITDA presented on the face of the financial statements has been validated, it is essential to strip out transaction adjustments by adding back items that understate the sustainable earning base or deducting items that overstate it. Some typical transaction adjustments include:

• Normalization: To determine the sustainable earning capacity of a business, the target reported EBITDA would undergo “Normalization”. Normalization focuses on adjusting historical items to reflect a run-rate capacity. The essence of normalization is to adjust items that are one-off, unusual or do not reflect normal operating conditions. Major adjustments include:

a. Non-recurring items: This is perhaps the most common transaction adjustment. Non-recurring items are simply transactions that an entity would typically not incur in the normal course of business and as a result are entirely one-off. For example, gains earned from selling off an asset of the business could be stripped off, restructuring costs for carving out a subsidiary can be added back, IT Infrastructure or ERP migration expenses can be added back, etc. Typical items under this category include gains from asset disposal, restructuring costs, one-time litigation expenses, government grants etc.

b. Owner compensation & discretionary items: Here advisors should investigate whether owner’s compensation exceeds or falls short of the market rate (salary to hire a different CEO). If lower than the market rate, then add back the difference. This is because to effectively run and manage the business, it actually costs more than the owner has historically charged. Thus, the company does not (and cannot) generate as much as it purports to generate. Owner’s discretionary items on the other hand include items which should not be charged as expense on the business but have historically caused higher expenses. These could include family members’ gifts, personal parties and club membership not associated with the business etc.

c. Related-party transactions: Accounting for transactions assumes intrinsically that every recorded transaction was conducted at arm’s length; that is, at market rate. However, transactions with related parties such as supply of materials (input), facility or equipment leasing, etc., conducted with sister entities are usually provided at highly discounted costs, or no costs at all. Upon acquisition, these privileges no longer exist. As a result, QoE will ensure the full extent of market rate during the historical period is reflected to determine the sustainable earnings base.

• Proforma Adjustments: Proforma Adjustments on the other hand focus on capturing the impact of events that have occurred already, but whose effects are yet to reflect in the financial performance due to their recency. For example, if a target received a letter of intent by December 2025, and due diligence commenced in January 2026. In February 2026, the target loses a customer those accounts for 30% of the sales volume. Since the base year for the transaction is 2025, and this even already happened in 2026, proforma adjustments treat this event like it already occurred in the historical period in order to assess the “go-forward” earnings rate. This is because the business cannot generate the 30% revenue lost from losing that customer and as a result EBITDA must be adjusted down. Typical proforma adjustments include reflecting impact of organic business expansions (like opening new stores in different locations), acquisitions, carve out & restructuring, payroll costs based on current headcounts, capacity expansion, acquisition of new licenses etc. All these can occur while negotiation or diligence is ongoing and results from these activities can be collected hence, the go-forward performance level should be reflected as if this information were already in the financial statements.

Conclusion

Quality of earnings is a critical aspect of Financial Due Diligence. It is essential to determining the sustainable, repeatable earnings base of a business. A common misconception is that QoE is simply to adjust down reported EBITDA. However, depending on the actual economic reality of the target, Adjusted EBITDA post-QoE could be higher or lower than reported EBITDA as revealed in this article. As a result, it is essential for founders and business owners to consult the services of proven deal advisors to help in navigating the complexities of determining a sustainable earnings capacity and to support negotiations with buyers.