Conducting Quality Of Earnings Analysis

Conducting Quality Of Earnings Analysis

Adjusts reported earnings for non-recurring items, accounting policy choices, and run-rate normalizations to derive a defensible adjusted EBITDA that buyers and lenders can underwrite.

When To Use

• Buy-side or sell-side due diligence requiring normalized earnings validation
• Evaluating a seller's CIM or management-prepared adjusted EBITDA
• Preparing or reviewing a QofE report for a letter of intent, financing package, or board presentation
• Assessing earnings sustainability when a target has lumpy revenue, owner-dependent operations, or recent acquisitions

Inputs To Gather

• Financial statements: 3 years of audited/reviewed P&L, balance sheet, and cash flow statements; trailing twelve months (TTM) interim financials
• Trial balance and general ledger detail: Monthly GL exports for the analysis period, with account-level detail sufficient to trace individual adjustments
• Management adjustments schedule: Seller's own pro forma or add-back schedule with supporting documentation
• Revenue detail: Customer-level revenue by month, contract backlog, and pipeline data
• Cost detail: Payroll registers, rent rolls, vendor invoices for material expense categories
• Tax returns: Corporate returns (or K-1s for pass-throughs) to cross-check reported income
• Related-party transaction list: All intercompany or owner-related transactions, compensation, leases, and service agreements

Workflow

1. Establish the reported earnings baseline

   • Map the P&L to a standard chart of accounts (revenue, COGS, gross profit, SG&A, EBITDA)
   • Reconcile reported net income to tax returns; flag discrepancies
   • Confirm D&A, interest, and tax add-backs match supporting schedules

2. Identify and categorize adjustments

   • Non-recurring items: Litigation settlements, one-time consulting projects, asset write-downs, PPP/EIDL forgiveness, natural disaster costs. Each item requires documentation proving it is truly one-time
   • Owner/related-party adjustments: Above-market owner compensation, personal expenses run through the business, below-market rent on owner-held real estate, related-party service fees. Benchmark replacement cost using market data [VERIFY comparable compensation benchmarks against industry surveys]
   • Accounting policy normalizations: Revenue recognition timing (ASC 606 vs. cash basis), inventory valuation method changes (FIFO/LIFO), capitalization vs. expensing thresholds, lease treatment under ASC 842 [VERIFY applicable GAAP standards if target uses IFRS or tax-basis accounting]
   • Run-rate / pro forma adjustments: Full-year impact of mid-period hires, price increases, facility openings/closings, lost or won contracts, cost savings from completed initiatives. Require evidence that the run-rate event has already occurred — do not accept projected synergies

3. Build the adjustment bridge

   • Present adjustments in a waterfall from reported EBITDA to adjusted EBITDA
   • Categorize each adjustment by type (non-recurring, owner/related-party, normalization, run-rate)
   • Show the impact by period (each fiscal year + TTM) to reveal trends
   • Assign a confidence tier to each adjustment: Supported (documented), Reasonable (management representation with partial backup), Unsupported (no documentation — flag for further diligence)

4. Analyze revenue and working capital quality

   • Assess customer concentration (top 10 customers as % of revenue); flag if any single customer exceeds 10-15%
   • Evaluate revenue sustainability: recurring vs. non-recurring mix, contract renewal rates, churn
   • Review net working capital trends; identify seasonal swings and normalize for a peg calculation
   • Check for channel stuffing indicators: revenue spikes at quarter-end, abnormal receivables aging, credit memo patterns

5. Stress-test and sensitize

   • Model adjusted EBITDA under conservative, base, and management cases
   • Quantify the aggregate dollar impact of unsupported or borderline adjustments
   • Compare adjusted EBITDA margin to industry benchmarks [VERIFY industry margin data source and peer set]

6. Compile the QofE deliverable

   • Executive summary with headline adjusted EBITDA range and key risk findings
   • Detailed adjustment schedule with line-item support references
   • Revenue and working capital analysis sections
   • Appendices: data request tracker, open items list, management representation gaps

Output

The final QofE deliverable should include:

• Adjusted EBITDA summary table: Reported vs. adjusted for each period analyzed, with a clearly labeled TTM figure
• Adjustment detail schedule: Each adjustment with description, amount by period, category, confidence tier, and supporting reference
• Revenue quality analysis: Concentration table, recurring revenue breakdown, trend commentary
• Net working capital analysis: Monthly NWC with seasonal normalization and proposed peg
• Key findings and risk factors: Bullet-point summary of material issues (unsupported add-backs, concentration risk, accounting policy concerns, pending litigation exposure)
• Open items list: Unresolved data requests or items requiring further investigation

Quality Checks

• Every adjustment ties to a specific GL account and has a cited source document or management representation
• Adjusted EBITDA reconciles cleanly from reported net income through each add-back layer
• No projected synergies or uncommenced cost savings are included in adjusted EBITDA (these belong in a separate synergy analysis)
• Customer concentration and revenue sustainability findings are consistent with the adjustment conclusions
• Tax return income reconciles to book income within an explainable variance
• All figures marked [VERIFY] have been flagged for jurisdiction-specific or data-source-dependent confirmation
• The deliverable has been reviewed for internal consistency: totals foot, periods align, and narrative matches the numbers