Why Quality of Earnings Analysis Is Critical

The importance of normalized EBITDA

A quality of earnings analysis strips reported EBITDA of one-time items, unusual expenses, and accounting policy choices to reveal the business's real, sustainable earnings power.

This normalization process typically adjusts reported EBITDA both up and down; the result often differs from the figure management presents first.

Testing the recurrence of revenue

The analysis distinguishes how much of the revenue is contractual and recurring versus one-off or project-based; this distinction directly affects the reliability of future cash flow forecasts.

Revenue built on high customer concentration or short-term contracts is treated as lower quality and can justify a discount in the valuation multiple.

Normalizing working capital

A quality of earnings analysis typically also establishes a normalized working capital level; this level becomes the reference point in the deal's pricing mechanism, particularly in a completion accounts structure.

For businesses with seasonal swings, using a 12-month average working capital level instead of a single date offers a fairer reference point.

The effect of accounting policy choices

Accounting choices such as revenue recognition timing, inventory valuation method, or expense capitalization policy can present the same economic reality as different profit figures.

The analysis aims to restate the target's accounting policies against the buyer's own standards to arrive at a comparable profit figure.

The value of working closely with the management team

An effective quality of earnings analysis doesn't stop at looking at the numbers from the outside; conversations with the management team are critical to understanding the business logic behind the figures and the rationale for each adjustment.

This collaboration also lets the seller test their own normalization assumptions early and enter the negotiation better prepared.

Frequently asked questions