Beyond reported EBITDA, buyers should examine non-recurring items, working-capital movements and the sustainability of earnings. These details can change the view of value.

EBITDA is one of the most widely used measures in business valuation and mergers and acquisitions (M&A). It helps buyers and investors compare operating performance, assess profitability, and estimate the value of a business. However, reported EBITDA does not always tell the complete story.

A company may report strong earnings while relying on one-time revenue, unusual accounting adjustments, or temporary cost reductions. Its working-capital requirements may also be increasing, affecting the cash available to support day-to-day operations.

This is where a Quality of Earnings (QoE) analysis becomes important. By examining the factors behind reported earnings, buyers can better understand whether financial performance is sustainable and whether the business is generating earnings that can reasonably continue after an acquisition.

What is a quality of earnings analysis?

A Quality of Earnings analysis is a financial due diligence process that evaluates the accuracy, sustainability, and underlying drivers of a company’s reported earnings.

Rather than accepting reported EBITDA at face value, the analysis examines revenue quality, operating expenses, accounting policies, working-capital movements, and cash conversion. It also evaluates adjustments proposed by management to determine whether they are supported by evidence and appropriate for valuation purposes.

The objective is to estimate a more reliable level of maintainable earnings that reflects the business’s ongoing operations.

A QoE analysis is not the same as a statutory audit. While an audit examines financial statements under the relevant auditing framework, a QoE review focuses on the financial factors that may influence a transaction, valuation, and the buyer’s expectations of future performance.

1. Identify non-recurring income and expenses

One of the first steps in a QoE review is identifying items that may distort the company’s underlying operating performance.

Examples include:

• One-time gains from asset disposals.

• Exceptional insurance recoveries.

• Unusual legal or settlement costs.

• Transaction-related advisory fees.

• Restructuring expenses.

• Revenue from contracts that are unlikely to recur.

Certain genuinely non-recurring expenses may be added back when calculating adjusted EBITDA, while non-recurring gains may need to be removed. However, each adjustment should be assessed individually and supported by appropriate documentation.

An expense described as “one-off” should not automatically be accepted as an add-back. If similar expenses appear repeatedly, they may form part of the business’s normal cost structure.

2. Assess the sustainability of revenue

Revenue growth is valuable only when the underlying business relationships and commercial activities can support it.

A QoE review examines how revenue is generated and whether the reported results are likely to continue. This may involve reviewing customer concentration, contract terms, renewal rates, pricing changes, sales volumes, and revenue-recognition practices.

For example, a business may experience a significant increase in revenue shortly before a proposed sale. Buyers should investigate whether this growth reflects genuine demand, a temporary increase in orders, accelerated billing, or revenue that depends on contracts unlikely to continue.

Understanding the sources of revenue helps buyers distinguish sustainable commercial performance from temporary improvements.

3. Examine working-capital movements

EBITDA does not capture all the cash required to operate a business. Changes in receivables, inventory, payables, and other working-capital items can significantly affect liquidity.

A company may report increasing EBITDA while customers take longer to pay invoices or inventory accumulates faster than sales. In such circumstances, reported profitability may not translate into stronger operating cash flow.

A working-capital review typically considers:

• Accounts receivable ageing and collection patterns.

• Inventory levels, valuation, and turnover.

• Supplier payment terms and outstanding payables.

• Customer advances and deferred revenue.

• Seasonal fluctuations in operating requirements.

• Historical monthly working-capital trends.

In an acquisition, the buyer and seller may agree on a normalised working-capital target. The amount delivered at completion can affect the final purchase-price adjustment under the transaction agreement.

4. Reconcile EBITDA with cash flow

A business can report positive EBITDA without generating equivalent cash. Differences may arise from slow collections, inventory investment, capital expenditure, tax payments, interest, or other cash requirements.

A QoE review therefore examines whether reported earnings are supported by actual financial activity.

This may include reconciling revenue with customer receipts, reviewing the movement in receivables, checking expense accruals, and assessing operating cash-flow trends.

Consistently strong earnings supported by cash generation can provide greater confidence in the quality of financial performance. Conversely, a persistent gap between reported profits and cash generation deserves further investigation.

5. Review accounting policies and management adjustments

Different accounting policies and estimates can affect reported earnings even when two businesses have similar underlying operations.

A QoE review may examine revenue recognition, inventory costing, provisions, capitalised expenses, accruals, and other accounting judgments. Where appropriate, adjustments may be required to improve consistency or correct errors.

Management may also present adjusted EBITDA that excludes selected costs or includes expected savings. Buyers should distinguish between:

• Historical normalisation adjustments: Changes intended to remove genuinely unusual items or reflect normal operating costs.

• Run-rate adjustments: Adjustments reflecting changes that have already occurred but are not fully represented in the historical period.

• Pro forma adjustments: Adjustments based on assumed changes, transactions, or future conditions that may not yet have been realised.

These categories should be documented separately. Expected synergies or future savings should not automatically be treated as established historical earnings.

6. Consider customer concentration and operating risks

The sustainability of earnings also depends on the business’s customers, suppliers, workforce, and commercial relationships.

A company that relies heavily on a small number of customers may face greater earnings volatility if a major contract is lost. Similarly, dependence on a limited number of suppliers or key employees may expose the business to operational risks.

Buyers should assess customer retention, contract duration, revenue concentration, gross-margin trends, and the business’s ability to maintain its current operating performance.

These factors help explain whether the reported earnings base is resilient or vulnerable to changes after the transaction.

7. Understand how QoE findings affect business valuation

Quality of Earnings findings can have a direct impact on acquisition negotiations.

Where the transaction valuation is based on an EBITDA multiple, a change in adjusted EBITDA can materially affect the indicated enterprise value.

Illustrative example:

Suppose a business reports EBITDA of AED 5 million. During due diligence, the buyer identifies AED 400,000 of unsupported earnings adjustments and AED 100,000 of genuine non-recurring expenses that may be added back.

The resulting illustrative adjusted EBITDA would be:

Reported EBITDA: AED 5,000,000
Less unsupported adjustments: AED 400,000
Add accepted non-recurring expenses: AED 100,000
Adjusted EBITDA: AED 4,700,000

If the agreed valuation multiple were 6 times adjusted EBITDA, the illustrative enterprise value would be AED 28.2 million rather than AED 30 million based on reported EBITDA.

This example is for illustration only. Actual adjustments depend on the evidence, transaction terms, and valuation methodology. Enterprise value is also distinct from equity value, which typically reflects additional adjustments for net debt and other agreed items.

8. What buyers should review before completing a transaction

A structured QoE review should go beyond the headline EBITDA figure.

Before completing an acquisition, buyers should consider whether they have:

1. Reconciled reported revenue and expenses to the underlying accounting records.

2. Evaluated one-time income, expenses, and management add-backs.

3. Reviewed revenue sustainability and customer concentration.

4. Analysed working-capital requirements and historical trends.

5. Assessed the relationship between EBITDA and operating cash flow.

6. Identified accounting-policy differences and potential adjustments.

7. Reviewed debt-like items and other financial obligations.

8. Documented the evidence supporting the adjusted earnings figure.

The findings can help buyers negotiate the purchase price, assess transaction risks, and determine whether additional protections or conditions are appropriate.