Quality of Earnings

Overview

A quality of earnings analysis tests how much of a company's reported profit is likely to recur. Reported earnings can be affected by one-off events, owner-specific costs, accounting policy choices, timing differences and acquisitions or disposals, so the headline figure is rarely the level a buyer or lender should rely on.

Because transactions are commonly priced as a multiple of EBITDA, every adjustment has a direct effect on value. We build a transparent bridge from reported to diligence-adjusted EBITDA, with each item supported by evidence and clearly classified.

What the service covers

The analysis looks beneath the income statement at what drives the result and whether it will continue:

• Non-recurring and exceptional items, such as restructuring, litigation, one-off projects and unusual gains or losses.
• Normalisation of owner and management costs, including above-market or below-market remuneration, related-party charges and personal expenses.
• Out-of-period items and the correct cut-off of revenue and costs.
• Accounting policy alignment, including revenue recognition, capitalisation of costs, provisions and the treatment of leases.
• Pro forma effects of acquisitions, disposals, new contracts, lost customers and price changes, presented on a run-rate basis.
• Revenue and margin analysis by customer, product and period, including concentration and seasonality.
• The relationship between earnings and cash generation.

Key activities and deliverables

Key activities

• Reconcile management accounts to the audited or statutory accounts and to the general ledger.
• Analyse the profit and loss account month by month over the period under review, including the latest twelve months.
• Identify and test candidate adjustments against invoices, contracts, payroll records and ledger detail.
• Assess accounting judgements and compare the policies applied with those the buyer or lender will use.
• Classify each adjustment as management-proposed or diligence-identified, and as one-off, run-rate or policy-related.
• Discuss the draft findings with management and update for their responses.

Deliverables

• An EBITDA bridge from reported to adjusted earnings, with commentary on each adjustment.
• Monthly and last-twelve-month earnings analysis.
• Revenue and gross margin analysis by customer, product and segment.
• A summary of accounting policy differences and their effect on earnings.
• A databook linking every figure to its source.

Our approach and methodology

We start from the accounting records and work outwards, so that the starting point is verified before any adjustment is made. Each adjustment is documented with the evidence we reviewed, the reasoning for the treatment and the amount attributable to each period.

We are deliberately even-handed. Adjustments that increase earnings are tested as rigorously as those that reduce them, and we distinguish between items that are certain, those that are judgemental and those we could not verify. Readers can then see the range of reasonable outcomes and the basis for our conclusion.

Benefits for clients

• A price or credit decision anchored on sustainable earnings.
• A transparent, auditable bridge that can be defended in negotiation.
• Early identification of unsustainable profit, aggressive accounting or customer concentration.
• A shared basis for covenant definitions and earn-out calculations.
• Better understanding of the business's true profit drivers for management and investors.

Who needs this service

A quality of earnings analysis is most valuable to:

• Buyers and investors pricing an acquisition on an earnings multiple.
• Sellers who want to support the earnings they are asking bidders to pay for.
• Lenders sizing debt against EBITDA or setting covenant levels.
• Businesses preparing for a refinancing, a recapitalisation or a minority investment.
• Boards and owners who want a reliable view of underlying performance.

Scope and limitations

Our work is advisory. It is not an audit or a review under auditing standards and does not provide assurance on the financial information. We rely on the information and explanations management provides, and we state the basis of preparation and any limitations in our report.