Quality of Earnings: The Gap Between Reported and Real Profit
In most transactions where the valuation multiple is debated at length, what actually determines the final price is not the multiple but the earnings figure it is applied to. That figure is almost never the profit in the income statement.
What normalising means
Quality of earnings analysis aims to find the company's sustainable earning power. One-off effects are stripped out of reported profit and understated costs are added back. The resulting figure is the earnings a buyer can assume will repeat after taking over.
Items that push profit up
Non-recurring income (gains on asset sales, litigation awards, foreign exchange gains), capitalisation of ordinary costs, deferred maintenance and capital expenditure, changes in inventory valuation method and insufficient provisioning for doubtful receivables — all of these lift reported profit above real earnings.
Items that push profit down
There are items working in the other direction, in the seller's favour: a founder taking below-market compensation, personal expenses borne by the company, related party transactions priced off market, and one-off advisory or restructuring costs.
Properly documented, these raise normalised earnings. Undocumented, the buyer simply disregards them — and the loss goes straight into the price.
Net debt and working capital
Alongside quality of earnings, the second technical heading that sets the price is the definition of net debt and the normal level of working capital. Off-balance-sheet obligations, severance provisions, deferred payments and seasonal working capital swings are all argued here.
In our experience the largest deviations in transaction price arise not from the multiple debate but from the two parties understanding these definitions differently. That is why we recommend putting the definitions in writing at the letter of intent stage.
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